How I look at valuation:
This is an admittedly crude way of doing things, but it is applicable to securities ranging from secured debt to bonds to preferred to common equity. It does not apply to financial institutions, which are another ball of wax entirely.
First I start with the financial statements for the last few years and year-to-date. What you want to do is get to a core EBITDA number for these periods as a starting point. So what is EBITDA? It is Earnings Before Income, Taxes and Depreciation & Amortization. It is an approximation of the unleverd (as if the company had no debt), tax free cash generation capabilities of a company, and it is relatively easy to calculate once you clean up a company's financial statements.
Before you calculate EBITDA, you will need to clean up a company's financial statements. What do I mean by this? Most companies have items appearing on their income statemnts from time to time that must be recognized but are not representative of a company's true earnings power. Examples might include gains on sales of assets/securities/businesses, losses on write-downs, derivatives gains or losses, restructuring charges, etc. There is a whole range of these things and what you take out and what you leave in is a judgement call. Mechanically, the way to do this is to take pre tax net income and add (for write ofs and other losses) or subtract (for gains) the "special" items that are in each period's financial statements. Then you will have a corrected earnings number that hopefully reflects underlying ability to generate cash.
How do we get to EBITDA? Start with your adjusted pre tax income and add back:
- Interest cost minus interest income
- depreciation and amortization
Interest expense and income you will usually see listed on the income statement. In a pinch, companies are required to report cash paid for interest either as part of the cash flow statement or in the notes to the financial statements. D & A may be presented on the income statement, but if they are not you will see them in the cash flow statement.
Now you have adjusted EBITDA numbers for your company for a few years andthe most recent YTD. What you can then do is compute some ratios:
- EBITDA minus Interest is the money a company has left over to invest, expand, pay dividends, pay down debt, etc. If this number is negative or declining without an obvious reason (and a reason could be as simple as we are in a recession and you have reason to think things will get better), this is a big red flag.
- EBITDA minus Interest minus Capital Expenditures (latter found in the cash flow statement) approximates free cash flow. This is what is left after a company has left after it has reinvested in the business. This can be a negative number if a company has found attractive investment opportunities worth going into debt to take advantage of.
- EDITDA/Operating Cash Flow, usually expressed as a %. This tells you how closely EBITDA (an approximation of cash flow) matches up with actual cash flow. If a company is expanding and using a lot of cash to invest in working capital (inventory and receivables, primarily), tthis might be well below 100%. If it is consistently below 100%, you would want to understand why this is the case.
- The big daddy of them all: EV/EBITDA. This is the valuation construct I usually use to keep me honest. EV stands for Enterprise Value. You calculate EV as follows: Short and long term debt minus cash plus preferred stock (if any) plus market cap. You then divide this by EBITDA to get EV/EBITDA. What does this tell us? The EV/EBITDA multiple gives us a nice yardstick to compare similar forms regardless of the amount of debt that they have because the formula puts them all on a level playing field (a dollar of market value of equity is considered the same as a dollar of debt). The best way to use EV/EBITDA is to 1) look at how it has changed over time for a company and industry and 2) compare companies within an industry. As a rule of thumb, not many public businesses trade for less 5 or 6 times EBITDA for any length of time unless something is seriously wring and (usually) EBITDA is expected to rapidly decline. Anything over 12 times EBITDA is either at a cyclical low point (and EBITDA is expected to recover sharply), is in a high growth mode, or is wildly overvalued.
A variant of EV/EBITDA is to look at total debt/EBITDA. This is a useful metric because you can compare how leveraged different companies in an industry are. You can also use it to evaluate a company's ability to take on leverage. Finally, you can also use it as a guide to knowing whether a company's bonds are an attractive investment even when there may be a lot of bad press, ratings downgrades, etc. On this last point, if you know that a company is levered to 3X EBITDA through the bonds and that EBITDA is probably not going to plunge even in the case of bankruptcy, the bonds might look very attractive at a double digit yield/fat dscount to par even if the company hasa non-trivial change of going bust.
I suspect this is a fair amount to absorb, so if I am being unclear go right ahead and ask questions or point out inconsistencies. The other important piece of analytical work you would need to do is building a forecast model for a company. If you are not scared off, I can go into how to do that on another thread.