At the end of the day, the value of a company is the present value of future cash flows, and multiples are a shortcut which we should be very careful not to rely too heavily on. EV (and thus, EV/EBIT or EV?EBITDA) has become an incredibly popular metric - arguably more popular than market cap nowadays - but I want to give a couple critiques, so that readers may form a more nuanced view.
1. It treats all debt equally. If you have two companies, each with $100m EBIT and $1b in debt, but the first pays only 3% on their long-term notes, whereas the second is paying 8%, the value of those companies is clearly very very different. Of course, if you're doing a DCF and you're using WACC, this will manifest via a higher discount rate for the second company; but if you're just doing EV/EBIT, it doesn't show up at all.
2. It treats all cash as if it's distributable. All companies need to keep some cash permanently on hand for liquidity reasons, and for some industries this can be a very significant sum. Airlines aim to keep ~20% of annual revenues in cash on the balance sheet. Netting this out of the market cap does not accurately represent economic reality.
Another little note - when you talk about EV/FCF, are you talking about FCFF (ie unlevered FCF ie FCF + interest) or FCFE, which is what we typically mean by FCF? Because EV/FCFF is the meaningful metric, not EV/FCFE.
Another great post Kevin and as I have said before, you are now the only substack I follow. Unfollowed everyone else. Since you give us valuable insights I would like to add some thoughts that I believe might be useful. I am a full time investor and I need a 7% real rate of return. For mature businesses I look at EV/Sustainable Earnings as my preferred valuation measure. For example lets say I expect sustainable NOPAT margins to be 10%. My benchmark is a 7% real rate of return. If I expect the sales to grow with real GDP (and there is no point in owning a business that won't grow with real GDP atleast) thats a 1% return. I want at least another 6% so I will not pay above a 16X EV/Sustainable Nopat. Ideally not above 13X after incorporating a margin of safety. For growth businesses the logic is the same ...its just that for the 1st 10 yrs you have to forecast earnings by year so its a 10 year DCF + terminal value calculated on principles above. And for Indexes I do exactly the same but drill down to Price/Sales as Sales always grow with GDP and profit margins of broad indexes are very easy to forecast as there is a TON of economic data. I invest in India, UK and US.
At the end of the day, the value of a company is the present value of future cash flows, and multiples are a shortcut which we should be very careful not to rely too heavily on. EV (and thus, EV/EBIT or EV?EBITDA) has become an incredibly popular metric - arguably more popular than market cap nowadays - but I want to give a couple critiques, so that readers may form a more nuanced view.
1. It treats all debt equally. If you have two companies, each with $100m EBIT and $1b in debt, but the first pays only 3% on their long-term notes, whereas the second is paying 8%, the value of those companies is clearly very very different. Of course, if you're doing a DCF and you're using WACC, this will manifest via a higher discount rate for the second company; but if you're just doing EV/EBIT, it doesn't show up at all.
2. It treats all cash as if it's distributable. All companies need to keep some cash permanently on hand for liquidity reasons, and for some industries this can be a very significant sum. Airlines aim to keep ~20% of annual revenues in cash on the balance sheet. Netting this out of the market cap does not accurately represent economic reality.
Another little note - when you talk about EV/FCF, are you talking about FCFF (ie unlevered FCF ie FCF + interest) or FCFE, which is what we typically mean by FCF? Because EV/FCFF is the meaningful metric, not EV/FCFE.
Thanks for your thoughtful feedback! I always look at FCFF, although I'll need to check if the ‘tools’ I use, use the same
Another great post Kevin and as I have said before, you are now the only substack I follow. Unfollowed everyone else. Since you give us valuable insights I would like to add some thoughts that I believe might be useful. I am a full time investor and I need a 7% real rate of return. For mature businesses I look at EV/Sustainable Earnings as my preferred valuation measure. For example lets say I expect sustainable NOPAT margins to be 10%. My benchmark is a 7% real rate of return. If I expect the sales to grow with real GDP (and there is no point in owning a business that won't grow with real GDP atleast) thats a 1% return. I want at least another 6% so I will not pay above a 16X EV/Sustainable Nopat. Ideally not above 13X after incorporating a margin of safety. For growth businesses the logic is the same ...its just that for the 1st 10 yrs you have to forecast earnings by year so its a 10 year DCF + terminal value calculated on principles above. And for Indexes I do exactly the same but drill down to Price/Sales as Sales always grow with GDP and profit margins of broad indexes are very easy to forecast as there is a TON of economic data. I invest in India, UK and US.
Thanks for sharing.Very interesting!
The chart in there is super useful. Thanks!
I love Adyen but it’s cash flows are much lower than your P/FCF suggests since merchant payables flow into OCF.
True. I kept it simple by using the fcf value from finchat.io. Thanks for the clarification!
Very educational