Posts tagged ‘earnings’
EBITDA: Sniffing Out the Truth
Financial analysts are constantly seeking the Holy Grail when it comes to financial metrics, and to some financial number crunchers EBITDA (Earnings Before Interest Taxes Depreciation and Amortization – pronounced “eebit-dah”) fits the bill. On the flip side, Warren Buffett’s right hand man Charlie Munger advises investors to replace EBITDA with the words “bullsh*t earnings” every time you encounter this earnings metric. We’ll explore the good, bad, and ugly attributes of this somewhat controversial financial metric.
The Genesis of EBITDA
The origin of the EBITDA measure can be traced back many years, and rose in popularity during the technology boom of the 1990s. “New Economy” companies were producing very little income, so investment bankers became creative in how they defined profits. Under the guise of comparability, a company with debt (Company X) that was paying interest expense could not be compared on an operational profit basis with a closely related company that operated with NO debt (Company Z). In other words, two identical companies could be selling the same number of widgets at the same prices and have the same cost structure and operating income, but the company with debt on their balance sheet would have a different (lower) net income. The investment banker and company X’s answer to this apparent conundrum was to simply compare the operating earnings or EBIT (Earnings Before Interest and Taxes) of each company (X and Z), rather than the disparate net incomes.
The Advantages of EBITDA
Although there is no silver bullet metric in financial statement analysis, nevertheless there are numerous benefits to using EBITDA. Here are a few:
- Operational Comparability: As implied above, EBITDA allows comparability across a wide swath of companies. Accounting standards provide leniency in the application of financial statements, therefore using EBITDA allows apples-to-apples comparisons and relieves accounting discrepancies on items such as depreciation, tax rates, and financing choice.
- Cash Flow Proxy: Since the income statement traditionally is the financial statement of choice, EBITDA can be easily derived from this statement and provides a simple proxy for cash generation in the absence of other data.
- Debt Coverage Ratios: In many lender contracts certain debt provisions require specific levels of income cushion above the required interest expense payments. Evaluating EBITDA coverage ratios across companies assists analysts in determining which businesses are more likely to default on their debt obligations.
The Disadvantages of EBITDA
While EBITDA offers some benefits in comparing a broader set of companies across industries, the metric also carries some drawbacks.
- Overstates Income: To Charlie Munger’s point about the B.S. factor, EBITDA distorts reality. From an equity holder’s standpoint, in most instances, investors are most concerned about the level of income and cash flow available AFTER all expenses, including interest expense, depreciation expense, and income tax expense.
- Neglects Working Capital Requirements: EBITDA may actually be a decent proxy for cash flows for many companies, however this profit measure does not account for the working capital needs of a business. For example, companies reporting high EBITDA figures may actually have dramatically lower cash flows once working capital requirements (i.e., inventories, receivables, payables) are tabulated.
- Poor for Valuation: Investment bankers push for more generous EBITDA valuation multiples because it serves the bankers’ and clients’ best interests. However, the fact of the matter is that companies with debt or aggressive depreciation schedules do deserve lower valuations compared to debt-free counterparts (assuming all else equal).
Wading through the treacherous waters of accounting metrics can be a dangerous game. Despite some of EBITDA’s comparability benefits, and as much as bankers and analysts would like to use this very forgiving income metric, beware of EBITDA’s shortcomings. Although most analysts are looking for the one-size-fits-all number, the reality of the situation is a variety of methods need to be used to gain a more accurate financial picture of a company. If EBITDA is the only calculation driving your analysis, I urge you to follow Charlie Munger’s advice and plug your nose.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing had no direct positions in any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Metrics Mix-Up: Stocks and Real Estate Valuation
When it comes to making money, investors choose from a broad menu of investment categories, ranging all the way from baseball cards and wines to collectible cars and art. Two of the larger and more popular investment categories are stocks and real estate. Unfortunately for those poor souls (such as me) analyzing these two classes of assets, the stock and real estate investor bigwigs have not come together to create an integrated metric system. Much the same way the United States has chosen to go it alone on a proprietary customary unit measurement system with Burma and Liberia – choosing inches and feet over centimeters and meters. On the subject of stock and real estate valuation, investors and industry professionals have been stubbornly defiant in designing unique and cryptic terminology, despite sharing the exact same financial principles.
Who Cares About Real Estate?
Well, apparently everyone. Southern California doesn’t have a monopoly on real estate, but through my practice in Orange County, I find it difficult to not trip over real estate investors on a daily basis. I work in effectively what was “ground zero” of the subprime debacle and the commercial real estate pains continue to ripple through “the OC.”
Ramping up the real estate learning curve reminds me of my high school Spanish class – I understood enough Spanish to work my way through a Taco Bell menu but little else. In order to actually learn Spanish I had to completely immerse myself in the language, even if it meant continually speaking to my classmates in Spanish through my alias (Paco).
Real Estate Foundational Terms
Despite being a relative new resident in the Orange County area, engrossing myself in real estate hasn’t been much of a challenge. Over a brief period, my interactions and conversations taught me my financial degrees and credentials were just as applicable in the realty world as they were in the stock market world. While evaluating real estate valuation techniques, I discovered two new key terms:
1) NOI (Net Operating Income): Unlike stock analysis, which uses “Net Income” as a core driver in determining an asset’s value, real estate relies on NOI. Net operating income is generally derived by calculating income before depreciation and interest expense. In finance, there are many versions of income. I’m sure there are more explanations, but two reasons behind the selection of NOI in real estate valuation over other metrics is due to the following: a) NOI may be used as a proxy for cash flow, which can be integral in many valuation techniques; and b) NOI is “capital structure neutral” if comparing multiple properties. Therefore, NOI allows an investor to compare varying properties on an apples-to-apples basis regardless of whether a property is massively leveraged or debt-free.
2) Cap Rate (Capitalization Rate): This ratio is computed by taking the NOI and dividing it by a property’s initial cost (or value). In stock market language, you can think of a “cap rate” as an inverted P/E (Price – Earnings) ratio – an inverted P/E ratio has also been called the “earnings yield.” Complicating terminology matters is the interchangeable use of income and earnings in the investment world. In the case of the P/E ratio, the denominator generally used is “Net Income.”
A shortcoming to the cap rate ratio, in my view, is the failure to deduct taxes. Although comparability across properties may get muddied, if determining profit availability to investors is the main goal, then I think an adjusted NOI (subtracting taxes) would be a more useful proxy for valuation purposes. Tax benefits associated with REITS (Real Estate Investment Trusts) complicates the metric usage issue further.
The simplistic beauty of marrying NOI and a cap rate is that a crude valuation estimate can be constructed by merely blending these two metrics together. For example, a commercial real estate property generating $500,000 in NOI that applies a 5% cap rate to the property can arrive at a valuation estimate of $10,000,000 ($500,000/.05).
Similarities between Stocks & Real Estate
At the end of the day, the theoretical value of ANY asset can be calculated by taking the projected after-tax cash flows and discounting that stream back into today’s dollars – whether we are talking about a stock, bond, derivative, real estate property, or other asset. Both stock and real estate analysis use readily available income numbers and price ratios to estimate cash flows and valuations. Regrettably, since real estate and equity investors generally play in different leagues, the rules and language are different.
The lingo used for analyzing separate asset classes may be unique, but the math and fundamental examination are the same. The formula for learning real estate is similar to that of Spanish – you need to dive in and immerse yourself into the new language. If you don’t believe me, just ask Paco.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing had no direct positions in YUM or any other security mentioned. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Sports & Investing: Why Strong Earnings Can Hurt Stock Prices
There are many similarities between investing in stocks and handicapping in sports betting. For example, investors (bettors) have opposing views on whether a particular stock (team) will go up or down (win or lose), and determine if the valuation (point spread) is reflective of the proper equilibrium (supply & demand). And just like the stock market, virtually anybody off the street can place a sports bet – assuming one is of legal age and in a legal betting jurisdiction.
Right now investors are poring over data as part of the critical, quarterly earnings ritual. Thus far, roughly 20% of the companies in S&P 500 index have reported their results and 78% of those companies have beaten Wall Street expectations (CNBC). Unfortunately for the bulls, this trend has not been strong enough to push market prices higher in 2010.
So how and why can market prices go down on good news? There are many reasons that short-term price trends can diverge from short-run fundamentals. One major reason for the price-fundamental gap is the following factor: expectations. Just last week, the market had climbed over +70% in a ten month period, before issues surrounding the Massachusetts Senatorial election, President Obama’s banking reform proposals, and Federal Reserve Bank Chairman Ben Bernanke’s re-appointment surfaced. With such a large run-up in the equity markets come loftier expectations for both the economy and individual companies. So when corporate earnings unveiled from companies like Google (GOOG), J.P. Morgan (JPM), and Intel (INTC) outperform relative to forecasts, one explanation for an interim price correction is due to a significant group of investors not being surprised by the robust profit reports. In sports betting lingo, the sports team may have won the game this week, but they did not win by enough points (“cover the spread”).
Some other reasons stock prices move lower on good news:
- Market Direction: Regardless of the underlying trends, if the market is moving lower, in many instances the market dip can overwhelm any positive, stock- specific factors.
- Profit Taking: Many times investors holding a long position will have price targets or levels, if achieved, that will trigger selling whether positive elements are in place or not.
- Interest Rates: Certain valuation techniques (e.g. Discounted Cash Flow and Dividend Discount Model) integrate interest rates into the value calculation. Therefore, a climb in interest rates has the potential of lowering stock prices – even if the dynamics surrounding a particular security are excellent.
- Quality of Earnings: Sometimes producing winning results is not enough (see also Tricks of the Trade article). On occasion, items such as one-time gains, aggressive revenue recognition, and lower than average tax rates assist a company in getting over a profit hurdle. Investors value quality in addition to quantity.
- Outlook: Even if current period results may be strong, on some occasions a company’s outlook regarding future prospects may be worse than expected. A dark or worsening outlook can pressure security prices.
- Politics & Taxes: These factors may prove especially important to the market this year, since this is a mid-term election year. Political and tax policy changes today may have negative impacts on future profits, thereby impacting stock prices.
- Other Exogenous Items: Natural disasters and security attacks are examples of negative shocks that could damage price values, irrespective of fundamentals.
Certainly these previously mentioned issues do not cover the full gamut of explanations for temporary price-fundamental gaps. Moreover, many of these factors could be used in reverse to explain market price increases in the face of weaker than anticipated results.
For those individuals traveling to Las Vegas to place a wager on the NFL Super Bowl, betting on the hot team may not be enough. If expectations are not met and the hot team wins by less than the point spread, don’t be surprised to see a decline in the value of the bet.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds and GOOG, but at the time of publishing had no direct positions in JPM and INTC. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
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