P/E multiples are thrown around a lot when talking about stocks, but there is a much better way to value stocks using multiples -- EBIT multiples. Don't be shocked. Just because I'm a value investor doesn't mean I do not look at multiples. I like to concentrate on value-based metrics such as P/FCF, which is a variation of P/E, and even EV/EBITDA, but the more tools I have and understand how and when to use them only helps me as an investor.
Given that most people use multiple valuation methods incorrectly, I will show you how to do it the proper way.
How People Perform Multiples Valuation
The All Too Common Way
You may have heard this sort of analysis before:
"DELL is trading at a P/E of 10.6x with a forward P/E of 8.7x. Its competitors are trading between 9x and 14x. If DELL corrects its problems, it should trade at similar multiples to its competitors. Therefore, DELL is worth $18."
Problems Doing It This Way
Right away, there are some fundamental flaws. I understand the importance of keeping things simple, but not so simple that it affects the whole underlying principle.
P/E is a broad metric that can vary greatly depending on adjustments to the income statement, such as:
- A goodwill charge can reduce earnings drastically, although it doesn't affect the business operation
- Income from discontinued operations can inflate P/E
EBIT Multiple Valuation Is The Better Way
You start with a normalized revenue estimate, enter a conservative, normal and aggressive operating margin to get the EBIT. Then decide what multiplier you want against EBIT, add cash and subtract debt to get a total equity value.
It's simple and doesn't remove everything just for the sake of keeping it simple. What's more, if you are looking at a company with several subsidiaries or operating segments that do vastly different things, you can apply the EBIT method for each segment and then add it up to get a sum-of-parts valuation.
Valuing DELL With EBIT Multiples
Let's jump straight into the numbers and see how this works. Here are the numbers and assumptions I am using for a normalized case:
- Over the past five to six years, I normalized the revenue to be $59 billion
- A normalized operating margin of 5.3% for a "normal" case
- A fair value EBIT multiple of 8x
- Add cash and subtract debt
Take a look at the image below to see how these assumptions are used to perform the EBIT valuation.
The numbers for cash and debt came from the stock analyzer spreadsheet and are verified against the latest 10-K.
DELL makes for an interesting case study because there are several big investors coming up with their own valuation targets, which we can reference.
- Michael Dell wants to buy out DELL at $13.65
- Carl Icahn has come out and said that he wants DELL to issue a $9 special dividend because he values it at $22.81
- Jim Chanos has revealed that he is short DELL going into the deal citing issues with the balance sheet and cash flow. (In other words, he doesn’t think it is worth $13.65.)
Although Jim Chanos has not revealed his target price, I believe it will likely be closer to $10, which is the lower end of the range. Michael Dell is hovering over the normalized case to get a slightly cheaper deal than the fair value. Carl Icahn is the optimistic and aggressive investor.
The question now becomes: Who is right based on the business model? It's too early to say at the moment.
Summary of the EBIT Multiples Method
As you can see, the EBIT valuation gives you a much better picture of a company and helps you take a step-by-step approach to valuing companies. That's something a simple multiple or rule-of-thumb method does not allow you to do.