Value investing refers to the strategy of investing in companies that are trading significantly below their historic averages and the market. Cyclical companies, such as energy, materials, and mining are considered to be value stocks during times when the cycle is in the bottom half. However, any company, regardless of industry, can be considered a value at different points in the business cycle.

Value stocks are characterized by low multiples, high payout ratios and strong yields. Common multiples -- price to earnings (P/E), price to book (P/B), enterprise value (EV), earnings before interest, taxes, depreciation and amortization (EBITDA) or the enterprise multiple -- are applied to ascertain the trading value of a stock. P/E looks at today's stock price relative to the earnings. P/B relates today's stock price to the book value of the company.

Each of these multiples has flaws. Enterprise multiple, however, is the most encompassing and generally considered the most useful in analyzing the current valuation of a stock.

Using the Enterprise Multiple for Stock Valuation

The enterprise multiple takes into account a company's debt and cash levels in addition to its stock price and relates that value to the firm's cash profitability. High payout ratios indicate the firm is returning cash to the shareholder in the form of dividends, rather than re-investing the profits in the company. Strong yields, particularly free cash flow yield, determine the return to the shareholder after all the cash expenses for operating a business and investment in capital expenditures are spent. Enterprise multiples can vary depending on the industry. Compare the multiple to other companies within the industry or to the average industry in general.

The multiple, also known as the EBITDA multiple, is calculated as:

Enterprise Multiple = Enterprise Value / EBITDA

What Is Enterprise Value?

Enterprise value is the total value of a company. Whereas multiples that use the stock price look only at the equity side of a stock, enterprise value includes a company's debt, cash and minority interests. It is calculated as market capitalization (stock price times shares outstanding) plus net debt (total debt minus cash and equivalents) plus minority interest. Investors use enterprise value to determine how debt financing, corresponding interest payments and joint ventures impact a company's value.

What Is EBITDA?

EBITDA is calculated from the income statement. As the name implies, it is calculated as operating profit, adding back depreciation and amortization. Analysts and companies use this as a measure of the true cash operating profit of a company since depreciation and amortization are non-cash items and taxes and interest are not considered part of the operations of the company even though these two items impact earnings.

(For further reading, see EBITDA: Challenging the Calculation.)

Determining the Enterprise Multiple

Proper and optimal capital structure is the key to a company's ability to operate profitably and thus should be considered when valuing a stock.

EV is an appropriate way to measure the value of the entire company rather than just the stock price, which looks only at the equity market capitalization of the stock, ignoring the company's cash, minority interests and debt. The enterprise multiple compares the total value of a company relative to its cash profits. It is often more desirable than P/E because EBITDA is considered less susceptible to being manipulated than earnings and P/B since it is a better measure of cash profitability than book value. However, it is not without its flaws. Consider using more appropriate multiples when valuing highly-levered companies where debt servicing, long-lived assets or book value drives profitability.

Stocks with an enterprise multiple of less than 7.5x based on the last 12 months (LTM) is generally considered a value. However, using a strict cutoff is generally not appropriate because this is not an exact science. Often investors will consider enterprise multiples below the market, the company's peers and its historical average of a stock as a good entry point.

However, cyclical stocks usually have a wide dispersion between the peak (high) and trough (low). This creates the need to take the current multiple in context, including where the industry and company are in their cycle, the fundamentals of the industry, and the catalysts driving the stock relative to its peers. Considering these factors will determine whether the LTM multiple is inexpensive or expensive.

(Discover the differences between stocks in different industries, in Cyclical Versus Non-Cyclical Stocks.)

Look Out For Value Traps

Value traps are stocks with low multiples. This creates the illusion of a value investment, but the fundamentals of the industry or company point toward negative returns.

Investors tend to assume that a stock's past performance is indicative of future returns and when the multiple comes down, they often jump at the opportunity to buy it at such a "cheap" value. Knowledge of the industry and company fundamentals can help assess the stock's actual value.

One easy way to do this is to look at expected (forward) profitability (EBITDA) and determine whether the projections pass the test. Forward multiples should be lower than current LTM multiples; if they are higher, it generally means the profits will be declining and the stock price is not yet reflecting this decline. Sometimes forward multiples can look extremely inexpensive. Value traps occur when these forward multiples look overly cheap, but the reality is the projected EBITDA is too high and the stock price has already fallen, likely reflecting the market's cautiousness. As such, it's important to know the company's and industry's catalysts.

(Check out Value Traps: Bargain Hunters Beware for further reading.)

The Bottom Line

Investing in stocks requires knowledge of a company's fundamentals, assessing its peers and using a common denominator, such as the enterprise multiple. The enterprise multiple is a proxy for how inexpensive or expensive a stock is trading today based on past and expected cash flows. However using the enterprise multiple is not foolproof and even if a stock is cheap on a multiple basis, market sentiment may be negative.

(To learn from the original value investor, read The Intelligent Investor: Benjamin Graham.)

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