The preponderance of investment strategists believe stocks are in the range of oversold to extremely undervalued. Few, if any, investors or analysts disagree. In fact, last week, Barton Biggs, the highly-regarded investment strategist predicted a market “pop” was due within days. So far, it has not come.
After all, stocks have fallen in the mid-teens from their peak, the economy is moving forward, housing appears to have bottomed, construction spending rose by its most sizeable margin in a decade, employment is slowly rising based on household survey data, and corporate officers are turning the corner of optimism during conference calls.
The problem with stocks, then, must assuredly be related to-take your pick-(a) sub-par growth in China, (b) Greece, (c) the Euro, or (d) the oil spill.
Or could it be (e) None of the above?
When security analysis is based solely on the profit and loss statement, as P/E and EBITDA multiples are, the analysis is lacking. This would not be true during bull markets because the risk portion of analysis is in abeyance, that is, the discount rate is low, and hence, a small rise in cash flow would, by itself, result in a magnified impact on a security’s fair value.
But EBITDA, like reported earnings suffers from distinct weakness:
For example, EBITDA:
- excludes important tax payments that represents a reduction in cash available;
- does not consider capital expenditure requirements for the assets being depreciated and amortized that may have to be replaced in the future;
- does not reflect changes in, or cash requirements in working capital needs; and
- does not reflect the significant interest expense, or the cash requirements necessary to service interest or principal payments, on debt.
Even in a merger analysis, for which EBITDA was originally intended, its use is limited. In addition to the above drawbacks, it may not be useful since it:
- does not include share-based employee compensation expense, goodwill impairment charges and other non-cash charges;
- does not include restructuring, severance and relocation costs incurred to realize future cost savings and enhance the operations of the entity;
- does not include the impact of business acquisition purchase accounting adjustments;
- does not reflect company sale transaction expenses and merger related expenses, and
- may include other adjustments required in calculating debt covenant compliance such as pro forma adjusted EBITDA for companies acquired during the year.
But how valid are those low P/E or EBITDA multiples when risk is rising?
A low valuation multiple would be overwhelmed by an increase in risk, the discount rate from which cash flows are brought to present value. I believe this is the case now, and is the primary reason analysts are bewildered by the low multiples. The other factor is much of the reported free cash flows are being consumed by share buybacks and a step up in capital spending.
Free cash flow is not the same as Earnings before Interest, Taxes, Depreciation and Amortization (EBITDA). EBITDA, because it is derived only from income statement inputs, comes with a big theoretical caveat: it fails to capture capital intensity, the proportion of cash flows that must be reinvested to maintain the business, including working capital. This varies structurally between industries and companies, which we why investors must look to growth rates when evaluating capital spending requirements. Calculating EBITDA is certainly a lot simpler than calculating free cash flow, which I go into detail in my text, “Security Valuation and Risk Analysis.”
Currently, EBITDA, P/Es and other naive measures of valuation are indeed signaling a inexpensive U.S. equity market. But when discounting by a proper cost of capital- which I will detail in my next blog-stocks are not so cheap-in fact,they are near fair value. The moral of this post is to always assign a proper discount rate to those earnings or preferably, those free cash flows. A single number ( a P/E), which is being relied on today by these prominent strategists, almost never tells the full story.
Kenneth S. Hackel, C.F.A.