People who use EBITDA are either trying to con you or they're conning themselves." - Warren Buffett
Neither Mr. Buffett nor Mr. Charlie Munger is particularly cordial about their interpretation of EBITDA. If you're willing to take these great investors at their word, then you're probably avoiding company valuations based on Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA). Nevertheless, there are so many "smart money" investors out there that rely on EBITDA for valuation - private equity firms, leveraged buy-out companies, merger and acquisition consultants, to name a few - there must be some advantage to viewing earnings in a different light. But if you're relatively new to investing, it seems like a daunting task to make the transition from a price/earnings ratio to an enterprise value/EBITDA ratio. There's such intense competition in the markets, among investors much smarter than I, employing complex valuation methods way above my pay grade. But while the complicated math lends itself to an unfair playing field, it turns out EBITDA is a way to boost corporate leverage through inflated projections - precisely the opposite of what we should be using it for. Consider this small excerpt from William Blair Investment Banking, whose researchers kindly provide insights into the M&A landscape via periodic newsletters:
In the first quarter of 2018, leverage levels reached their highest point since mid-2015, even though many financial sponsors are modeling for an economic downturn sometime over the next five years. In an effort to win deals in today's hyper-competitive landscape, some financial sponsors have begun accepting projected internal rates of return in the 12 to 16% range
Followed later by this graphic (among others):
Well, there you have it. Corporations are essentially leveraging themselves and borrowing money with unparalleled intensity. Simultaneously, consultants are projecting high returns in upwards of 16% (comparatively, the S&P 500 historically returns about 10% per year). Yet, the EV/EBITDA multiple for merger and acquisition activity has remained virtually constant since 2006. If this doesn't get you thinking about corporate America's insatiable taste for debt, and the animal instinct financial consultants employ to force deals and prop up numbers, I don't know what will.
That brings us back to Mr. Buffett, and his inference toward standard GAAP earnings as a prerequisite for financial valuation, rather than EBITDA. Why take a relatively simple idea - businesses generating a profit - and complicate it to the point of incredulous valuation? Is there an upside? According to the Corporate Finance Institute, EBITDA is a metric that is remarkably similar to the free cash flow to the firm, so to speak. It allows analysts to place value on businesses in terms of the cash earned, removing the effect of outside forces like taxes and capitalization structure.
EBITDA […] focuses on the operating decisions of a business because it looks at the business' profitability from its core operations before the impact of capital structure, leverage, and non-cash items like depreciation are taken into account.
If M&A consultants and finance professionals consider EBITDA as a viable valuation metric, then there must be some validity to it that outweighs Mr. Buffett's scorn. It turns out there is. As a small example, consider two companies A and B. In the same year, they both earn a profit of $1 million, both trade at $10/share, with one million outstanding shares. Assume the companies also share the same interest, tax, depreciation, and amortization charges of $1 million (giving each company $2 million in EBITDA). They even have similar balance sheets, except for one line item: Company B has $5 million in long-term debt. All things held constant, at $10/share, which company is cheaper?
After glossing over the table, CFAs and Accountants across the globe are cringing at my perceived ignorance. My example is primitive: If Company "B" is $5 million in debt, there's absolutely no way both businesses would have the same interest expenses. Company B would be paying interest on its debt, making earnings lower, and therefore generating a more expensive P/E ratio. But before scolding me for my accounting brevity, let me say this: it doesn't matter! Sure, the interest expenses would be different for each business, but not with an effect large enough to skew my purpose… it is not EBITDA that helps us, but the EV/EBITDA multiple.
At any rate, of course Company A is cheaper! It has no debt. But if you were working strictly off of a P/E ratio, then you might not be able to see any real differences in the capitalization and valuation of a business. And therein lies the intrinsic value of EV/EBITDA multiples: it accounts for debt on a company's balance sheet. From an M&A standpoint, it is the value of cash generated by a business, and represents the "con" purported by CEOs and financial consultants alike. However, from an investor's standpoint, using EV/EBITDA as metric enriches the analysis, because it considers the amount of leverage a corporation has invoked. It is a way to connect the balance sheet to the income statement, and serving as a capitalization bellwether. We will see this connection through three examples - NXP Semiconductors (NXPI), D.R. Horton (DHI), and Community Health Systems (CYH). Each company has a different enterprise value and capitalization structure that leads to varying P/E and EV/EBITDA multiples. We will see that in complementary fashion, incorporating EV/EBITDA analysis can lead to widely different valuations.
NXP Semiconductors: the broken M&A chapter begins
In a recent post, I highlighted the plausibility of NXPI as a worthy merger-arb investment, only to be denied by Chinese President Xi Jinping and the newly formed State Market Regulatory Administration (or in the more politically correct sense, the SMRA let Qualcomm's (QCOM) self-imposed timeline expire). The now defunct deal had a closing price of $127.50, but likely due to Chinese trade war tensions and forced selling by merger-arbitrageurs, NXPI prices have been weighed down.
With approximately $6 billion in debt versus $32 billion in market cap, NXPI is underlevered. Furthermore, at $95/share, NXPI trades at a 2017 P/E of 14.5x and a 2017 EV/EBITDA of 9.2x. Those are fairly decent multiples, if for no other reason than the historical P/E ratio for the S&P 500 is 15x, and from our William Blair note, a 10x EV/EBITDA is near the low end of the M&A range. Given that Qualcomm was willing to pay 34% more than the current price, NXP trades cheaply.
D.R. Horton and the homebuilding soiree
D.R. Horton is the largest American homebuilder by volume. It operates in 80 markets across 26 states. It engages in the construction and sale of homes through its D.R. Horton, Express Homes, and Emerald Homes brands, and also provides mortgage financing to homebuyers. Over the past five years, DHI has grown sales at 22.5% per year, making it a homebuilder with a decent competitive advantage, not to mention favorable family ownership (Mr. Horton owns more than 6% of the shares).
The trade war anxiety underlying the markets didn't seem to have much of an effect on D.R. Horton's recent quarterly report. Net income and net sales orders increased 57% and 13% year over year, respectively, and management upped its fiscal 2018 guidance. To paraphrase the conference call, the housing market is setting up well for DHI. There's a lot of buyers, but a shortage of inventory, giving the company some pricing power.
We are experiencing healthy market conditions across most of our markets with solid demand, especially at affordable price points. And the supply of new homes remains limited. In this environment, we are reducing sales incentives or raising prices in communities where we are achieving our targeted sales base while striving to ensure that our product offerings remain affordable. Land and construction costs are generally increasing and we are utilizing our scale and relationships to control cost increases. (Jessica Hansen - DHI 2018 Q3 Conference Call)
It sounds like the American economy is rolling along, and D.R. Horton appears ready to capture the opportunity. Even though we are operating in a rising interest rate environment (which does not bode well for home prices), DHI has the makings of a competitive business with combined scale and pricing power. At $44/share, DHI trades to a 16x P/E and 10.9x EV/EBITDA. Those are based on 2017 financials, but with three quarters of growth in the books there is reason to believe it trades more cheaply.
As an interesting experiment, one way to harness the power of EV/EBITDA is to reverse-engineer share prices from various multiples. It takes a little bit of math, but below is a small matrix of P/E and EV/EBITDA multiples with corresponding shares prices. Theoretically, we should be able to see how leveraged DHI is, depending on the range of share prices. The wider the range of share prices, the more leveraged the company is. Conversely, a tight range - what we see in DHI's case - implies a relatively moderate capitalization structure:
It makes perfect sense that increasing the P/E from 10x to 15x, a 50% jump, would correspond to the same increase in price per share. However, the same idea doesn't hold true for EV/EBITDA. A 50% percent increase (from 10x to 15x) in EV/EBITDA translates to a 55% increase in price. Why? It is largely because of the ~$2.5 billion in notes payable on DHI's balance sheet (again, 2017 financials). Given that DHI boasts a $23 billion market cap, the company is far from overlevered, but based off of our assumption that M&A deals never really cross a 15x EV/EBITDA multiple, one would have to compose further research to determine if DHI could ever reach a price greater than $62/share.
Community Health Systems and the storyline of leverage
Community Health Systems is one of the largest publicly traded hospital companies in the U.S. (albeit with a relatively minute $375 million market cap). As of December 2017 CYH owned/leased 125 hospitals in 19 states. The enterprise employs 2,000 doctors and 1,000 licensed practitioners. However, there is another side of the story. The company has spent the past few years divesting hospitals, including a 38-rural-hospital spinoff that took the form of Quorum Health Corporation (QHC), in order to deleverage its balance sheet:
We have been implementing a portfolio rationalization and deleveraging strategy by divesting hospitals and non-hospital businesses that are attractive to strategic and other buyers. Generally, these businesses are not in one of our strategically beneficial service areas, are less complementary to our business strategy and/or have lower operating margins. (2017 10-K pg. 1)
Formerly owning a long position in CYH because of the event-driven spinoff, I eventually turned negative on the company for a rather simple reason: debt. The equity trades at a glaringly small price, which to my untrained eye carries the guise of an opportunity. But the markets know better:
With a $375 million market cap, and $13.7 billion in debt, Community Health is highly leveraged. In fact, I estimate its 2018 operating profit to be somewhere in the vicinity of $500 million, while its interest expenses will cost over $900 million. Carrying these figures over to the EV/EBITDA discussion, below is another matrix of multiples for CYH, based off the most recent balance sheet and 2018 estimates.
Notice that first off, a P/E matrix cannot be formed, because the company has reported negative net income. Second, due to the high levels of debt enveloping CYH's capitalization structure, there are extraordinary price discrepancies related to different multiples. We can clearly see that a 50% increase in EV/EBITDA does not translate to the same increase in price (as opposed to the P/E scenario). Not only that, in order to trade at a high-end EV/EBITDA multiple, CYH prices would have to increase 20-fold. That said, it's fair to say CYH is a speculative stock that could trade wildly, due in large part to a highly leveraged structure.
While a traditional value-based analysis using a price/earnings ratio can certainly do the trick - and any rational value investor would pass over a business with negative earnings - it does not necessarily tell the whole story. An enterprise value/EBITDA metric, on the other hand, has a complementary ability to incorporate the capitalization structure into the valuation, making it more dynamic than its net income counterpart. A word of caution though, because as Warren Buffett and other value investors have stated, EBITDA itself can be a con, a way to inflate the cash a business generates, while avoiding real costs like capital expenditures. Nevertheless, observing certain historical guidelines of P/E and EV/EBITDA can provide additional insight into whether or not a company has value, and how that value is distributed across the capitalization.
Disclosure: I am/we are long DHI, NXPI, QCOM, QHC.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am/we are short CYH.
Nothing contained in this message is an offer or solicitation to buy or sell any security/investment, and is for informational purposes only. The author does not guarantee the accuracy or completeness of the information provided in this document. All statements and expressions herein are the sole opinion of the author and are subject to change without notice. Neither the author nor any of its affiliates accepts any liability whatsoever for any direct or consequential loss howsoever arising, directly or indirectly, from any use of the information contained herein.