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Course Section 4 - Lesson 3
Every stock trades at a different price. Every company is a different size. No two companies generate the same revenue or earn the same profit. Yet, as investors, we are somehow supposed to dig through thousands of companies and identify attractive opportunities.
If you've made it to this point in the course, you should have a good idea of how to identify promising companies. But how do you know when the stock of these companies is trading at an attractive price? We could always attempt to estimate and discount future cash flows. But as we learned a few lessons ago, DCF is far too sensitive to estimation error to generate actionable valuations. Enter valuation multiples.
What are Valuation Multiples?
Earlier, we learned how to analyze financial statements by creating ratios that compare business metrics through time and across companies. These ratios are easy to compute and facilitate quick and easy comparisons.
Valuation multiples are similar to financial statement ratios, except that the primary input is the company's current market value. The market value of a company can be defined in a number of ways: current stock price, total market capitalization, the value of the enterprise (including debt). What makes this metric particularly useful is the fact that it can be observed in real-time.
Without question, the most popular valuation multiple is the Price to Earnings Ratio. This ratio reflects the current price of a company's stock divided by its earnings per share. The P/E ratio provides investors with an indication of how expensive a stock is.
If Company A earns $1 in profit this year and its stock trades at $20, we can compute its P/E ratio is 20x. If Company B earns $2 in profit this year and its stock trades at $30, we can calculate its P/E ratio to be 15x.
According to this valuation methodology, we would say that Company B is less expensive than Company A, even though the stock price of Company B is higher (at $30). We say this because investors only have to pay $15 for every dollar of earnings that Company B generates, compared to $20 for a dollar of Company A's earnings.
Flavors of Valuation Multiples
While the price to earnings ratio is the most popular valuation multiple, there are many ways to combine a company's characteristics to determine its value. In the next lesson, we are going to explore why you should choose a specific multiple. But for now, I'd like to look more closely at what figures we combine to create these multiples.
The first figure we need to select when creating a valuation multiple is the metric by which we will determine the company's value. In practice, we have three choices: the price of a company's stock, its total market capitalization, or its enterprise value.
Price Based Ratios - Price ratios are simple to compute. A stock's price is always readily available and easy to find. The only thing that you need to be aware of when calculating price-based ratios is that everything is measured on a per-share basis.
Market Capitalization Ratios - The market capitalization of a company is equal to the value of all of its outstanding stock. To find this figure, you simply multiply the price of a company's shares by its stock price. Market capitalization-based ratios will give investors the exact same reading as a price-based ratio, without the need to convert operating results to per-share figures.
Enterprise Value Ratios - The enterprise value of a company is equal to the total value of a company's business. This figure includes the value of both debt and equity after removing cash. Enterprise value provides a more complete assessment of a company's total value than market cap because it includes both debt and equity. Enterprise value ratios can alleviate some of the difficulty of comparing two companies that utilize significantly different debt levels.
Once a valuation metric has been selected, you must then decide by how you will measure a company's current valuation. It's common to see valuation ratios calculated on Sales, EBIDTA, EBIT, and Earnings. Each of these ratios provides useful information about how the market values certain companies in specific industries.
Why So Many Valuation Ratios Exist?
At this point, you're probably asking yourself why so many valuation ratios exist and what each of them could possibly tell us over another. There are a couple of answers to this question, but let's begin to answer it by looking at a chart:
The chart above plots Texas Roadhouse's P/E ratio against its EV/Revenue ratio from 2010 to today. Something that jumps out immediately is the fact that the EV-to-Revenue ratio is significantly more stable than the price-to-earnings ratio. Why is this?
The excess volatility arises from two areas:
a company's stock price is much more volatile than the total value of the organization, and
a company's earnings are much more volatile than its revenue.
The volatility of the P/E ratio can make it difficult to compare over time and across companies. Because of this, I tend to gravitate towards valuation ratios that remove as much uncertainty as possible from my estimation of the company's true value.
This preference leads me towards a bias to multiples based on Enterprise Value and metrics that occur higher up on an organization's income statement.
Earnings are a Weak Predictor of the Future
When you think about the most commonly used metrics in valuation ratios: Revenue, EBITDA, EBIT, and Net Income. As you move down the income statement, making forward-looking estimates about each metric becomes more and more difficult. On top of that, the benefit you receive, as an investor, for using a more precise measure of operational success is low.
What we care about as long-term investors is whether or not a business can operate profitably. Making that determination can occur from looking at a company's earnings before interest, taxes, depreciation, and amortization (EBITDA) or in the case of capital intensive business earnings before interest and taxes (EBIT). We shouldn't need to introduce the volatility that occurs by deducting interest and taxes from a company's operating profits to assess its current valuation.
Ratios I Recommend
Throughout the rest of this section, we will be looking at valuation ratios for Texas Roadhouse and its competitors. I'll be focusing on three ratios in particular: EV/Revenue, EV/EBITDA, and EV/EBIT. It's been my experience that these three valuation ratios can tell investors what they need to know without bogging them down with needless and difficult to interpret information.
In previous lessons, we've discussed how Tikr.com makes it easy to find and aggregate data on companies you are analyzing, and that continues to hold for valuation ratios. They have an entire page of valuation ratios, including those I referenced above, that are automatically calculated for every publicly traded company.