Financial Statements - The Balance SheetThe balance sheet provides information on what the company owns (its assets), what it owes (its liabilities) and the value of the business to its stockholders (the shareholders' equity) as of a specific date. It's called a balance sheet because the two sides balance out. This makes sense: a company has to pay for all the things it has (assets) by either borrowing money (liabilities) or getting it from shareholders (shareholders' equity).

Assets are economic resources that are expected to produce economic benefits for their owner

Liabilities are obligations the company has to outside parties. Liabilities represent others' rights to the company's money or services. Examples include bank loans, debts to suppliers and debts to employees.

Shareholders' equity is the value of a business to its owners after all of its obligations have been met. This net worth belongs to the owners. Shareholders' equity generally reflects the amount of capital the owners have invested, plus any profits generated that were subsequently reinvested in the company.

The balance sheet must follow the following formula:

Total Assets = Total Liabilities + Shareholders\' Equity

Each of the three segments of the balance sheet will have many accounts within it that document the value of each segment. Accounts such as cash, inventory and property are on the asset side of the balance sheet, while on the liability side there are accounts such as accounts payable or long-term debt. The exact accounts on a balance sheet will differ by company and by industry, as there is no one set template that accurately accommodates the differences between varying types of businesses.

A balance sheet looks like this:

Source: http://www.edgar-online.com

Here are the entries you'll find on a balance sheet and what each one means. Total AssetsTotal assets on the balance sheet are composed of the following:

Current Assets - These are assets that may be converted into cash, sold or consumed within a year or less. These usually include:

Cash - This is what the company has in cash in the bank. Cash is reported at its market value at the reporting date in the respective currency in which the financials are prepared. Different cash denominations are converted at the market conversion rate.

Marketable securities (short-term investments) - These can be both equity and/or debt securities for which a ready market exists. Furthermore, management expects to sell these investments within one year's time. These short-term investments are reported at their market value.

Accounts receivable - This represents the money that is owed to the company for the goods and services it has provided to customers on credit. Every business has customers that will not pay for the products or services the company has provided. Management must estimate which customers are unlikely to pay and create an account calledallowance for doubtful accounts. Variations in this account will impact the reported sales on the income statement. Accounts receivable reported on the balance sheet are net of their realizable value (reduced by allowance for doubtful accounts).

Notes receivable - This account is similar in nature to accounts receivable but it is supported by more formal agreements such as a "promissory notes" (usually a short-term loan that carries interest). Furthermore, the maturity of notes receivable is generally longer than accounts receivable but less than a year. Notes receivable is reported at its net realizable value (the amount that will be collected).

Inventory - This represents raw materials and items that are available for sale or are in the process of being made ready for sale. These items can be valued individually by several different means, including at cost or current market value, and collectively by FIFO (first in, first out), LIFO (last in, first out) or average-cost method. Inventory is valued at the lower of the cost or market price to preclude overstating earnings and assets.

Prepaid expenses - These are payments that have been made for services that the company expects to receive in the near future. Typical prepaid expenses include rent, insurance premiums and taxes. These expenses are valued at their original (or historical) cost.

Long-Term assets - These are assets that may not be converted into cash, sold or consumed within a year or less. The heading "Long-Term Assets" is usually not displayed on a company's consolidated balance sheet. However, all items that are not included in current assets are considered long-term assets. These are:

Investments - These are investments that management does not expect to sell within the year. These investments can include bonds, common stock, long-term notes, investments in tangible fixed assets not currently used in operations (such as land held for speculation) and investments set aside in special funds, such as sinking funds, pension funds and plan-expansion funds. These long-term investments are reported at their historical cost or market value on the balance sheet.

Fixed assets - These are durable physical properties used in operations that have a useful life longer than one year. This includes:

Machinery and equipment - This category represents the total machinery, equipment and furniture used in the company's operations. These assets are reported at their historical cost less accumulated depreciation.

Buildings or Plants - These are buildings that the company uses for its operations. These assets are depreciated and are reported at historical cost less accumulated depreciation.

Land - The land owned by the company on which the company's buildings or plants are sitting on. Land is valued at historical cost and is not depreciable under U.S. GAAP.

Other assets - This is a special classification for unusual items that cannot be included in one of the other asset categories. Examples include deferred charges (long-term prepaid expenses), non-current receivables and advances to subsidiaries.

Intangible assets - These are assets that lack physical substance but provide economic rights and advantages: patents, franchises, copyrights, goodwill, trademarks and organization costs. These assets have a high degree of uncertainty in regard to whether future benefits will be realized. They are reported at historical cost net of accumulated depreciation.

Total LiabilitiesLiabilities have the same classifications as assets: current and long term.

Current liabilities - These are debts that are due to be paid within one year or the

operating cycle, whichever is longer. Such obligations will typically involve the use of current assets, the creation of another current liability or the providing of some service.

Usually included in this section are:

Bank indebtedness - This amount is owed to the bank in the short term, such as a bank line of credit.

Accounts payable - This amount is owed to suppliers for products and services that are delivered but not paid for.

Wages payable (salaries), rent, tax and utilities - This amount is payable to employees, landlords, government and others.

Accrued liabilities (accrued expenses) - These liabilities arise because an expense occurs in a period prior to the related cash payment. This accounting term is usually used as an all-encompassing term that includes customer prepayments, dividends payables and wages payables, among others.

Notes payable (short-term loans) - This is an amount that the company owes to a creditor, and it usually carries an interest expense.

Unearned revenues (customer prepayments) - These are payments received by customers for products and services the company has not delivered or for which the company has not yet started to incur any cost for delivery.

Dividends payable - This occurs as a company declares a dividend but has not yet paid it out to its owners.

Current portion of long-term debt - The currently maturing portion of the long-term debt is classified as a current liability. Theoretically, any related premium or discount should also be reclassified as a current liability.

Current portion of capital-lease obligation - This is the portion of a long-term capital lease that is due within the next year.

4. Long-term Liabilities - These are obligations that are reasonably expected to be liquidated at some date beyond one year or one operating cycle. Long-term obligations are reported as the present value of all future cash payments. Usually included are:

Notes payables - This is an amount the company owes to a creditor, which usually carries an interest expense.

Long-term debt (bonds payable) - This is long-term debt net of current portion. Deferred income tax liability - GAAP allows management to use different

accounting principles and/or methods for reporting purposes than it uses for corporate tax fillings to the IRS. Deferred tax liabilities are taxes due in the future (future cash outflow for taxes payable) on income that has already been recognized for the books. In effect, although the company has already recognized the income on its books, the IRS lets it pay the taxes later due to the timing difference. If a company's tax expense is greater than its tax payable, then the company has created a future tax liability (the inverse would be accounted for as a deferred tax asset).

Pension fund liability - This is a company's obligation to pay its past and current employees' post-retirement benefits; they are expected to materialize when the employees take their retirement for structures like a defined-benefit plan. This amount is valued by actuaries and represents the estimated present value of future pension expense, compared to the current value of the pension fund. The pension fund liability represents the additional amount the company will have to contribute to the current pension fund to meet future obligations.

Long-term capital-lease obligation - This is a written agreement under which a property owner allows a tenant to use and rent the property for a specified period of time. Long-term capital-lease obligations are net of current portion.

Financial Statements - The Income StatementThe income statement measures a company's financial performance over a specific accounting period. Financial performance is assessed by giving a summary of how the business incurs its revenues and expenses through both operating and non-operating activities. It also shows the net profit or loss incurred over a specific accounting period, typically over a fiscal quarter or year. The income statement is also known as the "profit and loss statement" or "statement of revenue and expense."

The income statement is divided into two parts: the operating items section and the non-operating items section.

The operating items section discloses information about revenues and expenses that are a direct result of the regular business operations. For example, if a business creates sports equipment, then the operating items section would talk about the revenues and expenses involved with the production of sports equipment.

The non-operating items section discloses revenue and expense information about activities that are not tied directly to a company's regular operations. For example, if the sport equipment company sold a factory and some old plant equipment, then this information would be in the non-operating items section. Income statements can be presented in one of two ways: multi-step and single-step. Both single and multi-step formats conform to GAAP standards. Both yield the same net income figure; the main difference is how they are formatted, not how figures are calculated. The two formats are illustrated below in two simplistic examples:

Multi-Step Format

Single-Step Format

Net Sales  Net SalesCost of Sales  Materials and ProductionGross Income*  Marketing and AdministrativeSelling, General and Administrative Expenses (SG&A) 

Research and Development Expenses(R&D) 

Operating Income* 

Other Income & Expenses

Other Income & Expenses

Pretax Income

Pretax Income* TaxesTaxes Net Income Net Income (after tax)*

--

Sample Income Statement Now let's take a look at a sample income statement for company XYZ for Fiscal Year (FY) ending 2008 and 2009. Expenses are in parentheses.

Income Statement For Company XYZ FY 2008 and 2009

(Figures USD) 2008 2009

Net Sales1,500,000

2,000,000

Cost of Sales (350,000) (375,000)

Gross Income1,150,000

1,625,000

Operating Expenses (SG&A) (235,000) (260,000)

Operating Income 915,0001,365,000

Other Income (Expense) 40,000 60,000Extraordinary Gain (Loss) - (15,000)Interest Expense (50,000) (50,000)Net Profit Before Taxes (Pretax Income)

905,0001,360,000

Taxes (300,000) (475,000)Net Income 605,000 885,000

Here are some of the different entries that may be found on the income statement and what each one means.

Sales - These are defined as total sales (revenues) during the accounting period. Remember these sales are net of returns, allowances and discounts.

Cost of Goods Sold (COGS) - These are all the direct costs that are related to the product or rendered service sold and recorded during the accounting period. (Reminder: matching principle.)

Operating expenses - These include all other expenses that are not included in COGS but are related to the operation of the business during the specified accounting period. This account is most commonly referred to as "SG&A" (sales general and administrative) and includes expenses such as selling, marketing, administrative salaries, sales salaries, maintenance, administrative office expenses (rent, computers, accounting fees, legal fees), research and development (R&D), depreciation and amortization, etc.

Other revenues & expenses - These are all non-operating expenses such as interest earned on cash or interest paid on loans.

Income taxes - This account is a provision for income taxes for reporting purposes.

The Components of Net Income:

Operating income from continuing operations - This comprises all revenues net of returns, allowances and discounts, less the cost and expenses related to the generation of these revenues. The costs deducted from revenues are typically the COGS and SG&A expenses.

Recurring income before interest and taxes from continuing operations - In addition to operating income from continuing operations, this component includes all other income, such as investment income from unconsolidated subsidiaries and/or other investments and gains (or losses) from the sale of assets. To be included in this category, these items must be recurring in nature. This component is generally considered to be the best predictor of future earnings. However, non-cash expenses such as depreciation and amortization are not assumed to be good indicators of future capital expenditures. Since this component does not take into account the capital structure of the company (use of debt), it is also used to value similar companies.

Recurring (pre-tax) income from continuing operations - This component takes the company's financial structure into consideration as it deducts interest expenses.

Pre-tax earnings from continuing operations - Included in this category are items that are either unusual or infrequent in nature but cannot be both. Examples are an employee-separation cost, plant shutdown, impairments, write-offs, write-downs, integration expenses, etc.

Net income from continuing operations - This component takes into account the impact of taxes from continuing operations.

Non-Recurring ItemsDiscontinued operations, extraordinary items and accounting changes are all reported as separate items in the income statement. They are all reported net of taxes and below the tax line, and are not included in income from continuing operations. In some cases, earlier income statements and balance sheets have to be adjusted to reflect changes.

Income (or expense) from discontinued operations - This component is related to income (or expense) generated due to the shutdown of one or more divisions or operations (plants). These events need to be isolated so they do not inflate or deflate the company's future earning potential. This type of nonrecurring occurrence also has a nonrecurring tax implication and, as a result of the tax implication, should not be included in the income tax expense used to calculate net income from continuing operations. That is why this income (or expense) is always reported net of taxes. The same is true for extraordinary items and cumulative effect of accounting changes (see below).

Extraordinary items - This component relates to items that are both unusual and infrequent in nature. That means it is a one-time gain or loss that is not expected to occur in the future. An example is environmental remediation.

Cumulative effect of accounting changes - This item is generally related to changes in accounting policies or estimations. In most cases, these are non cash-related expenses but could have an effect on taxes.

Unusual or Infrequent ItemsIncluded in this category are items that are either unusual or infrequent in nature but they cannot be both.

Examples of unusual or infrequent items:

Gains (or losses) as a result of the disposition of a company's business segment including:

Plant shutdown costs Lease-breaking fees Employee-separation costs

Gains (or losses) as a result of the disposition of a company's assets or investments (including investments in subsidiary segments) including:

Plant shut-down costs Lease-breaking fees

Gains (or losses) as a result of a lawsuit Losses of operations due to an earthquake Impairments, write-offs, write-downs and restructuring costs Integration expenses related to the acquisition of a business

Extraordinary ItemsEvents that are both unusual and infrequent in nature are qualified as extraordinary expenses.

Example of extraordinary items:

Losses from expropriation of assets Gain (or losses) from early retirement of debt

Discontinued OperationsSometimes management decides to dispose of certain business operations but either has not yet done so or did it in the current year after it had generated income or losses. To be accounted for as a discontinued operation, the business must be physically and operationally distinct from the rest of the firm. Keep in mind these basic definitions:

Measurement date – This is the date when the company develops a formal plan for disposing.

Phase-out period – This is the time between the measurement date and the actual disposal date.

The income or loss from discontinued operations is reported separately, and past income statements must be restated, separating the income or loss from discontinued operations.On the measurement date, the company will accrue any estimated loss during the phase-out period and estimated loss on the sale of the disposal. Any expected gain on

the disposal cannot be reported until after the sale is completed (the same rule applies to the sale of a portion of a business segment).

Accounting ChangesAccounting changes occur for two reasons:

1. As a result of a change in an accounting principle.2. As a result of a change in an accounting estimate.

The most common form of a change in accounting principle is the switch from the LIFO inventory accounting method to another method such FIFO or average cost basis.

The most common form of a change in accounting estimates is a change in depreciation method for new assets or change in depreciable lives/salvage values, which is considered a change in accounting estimates and not a change in accounting principle. Note that past income does not need to be restated from the LIFO inventory accounting method to another method such FIFO or average cost basis.

In general, prior years' financial statements do not need to be restated unless it is a change in:

Inventory accounting methods (LIFO to FIFO) Change to or from full-cost method (This is used in oil and gas exploration. The

successful-efforts method capitalizes only the costs associated with successful activities while the full-cost method capitalizes all the costs associated with all activities.)

Change from or to percentage-of-completion method (see revenue-recognition methods)

All changes just prior to a company's IPO

Prior Period AdjustmentsThese adjustments are related to accounting errors. These errors are typically not reported in the income statement but are reported in retained earnings (found in changes in retained earnings). These errors are disclosed as footnotes explaining the nature of the error and its effect on net income.

Financial Statements - Cash FlowThe statement of cash flow reports the impact of a firm's operating, investing and financial activities on cash flows over an accounting period.

The cash flow statement shows the following:

How the company obtains and spends cash Why there may be differences between net income and cash flows

If the company generates enough cash from operation to sustain the business

If the company generates enough cash to pay off existing debts as they mature

If the company has enough cash to take advantage of new investment opportunities

Segregation of Cash FlowsThe statement of cash flows is segregated into three sections:

Operating activities Investing activities Financing activities

1. Cash Flow from Operating Activities (CFO)CFO is cash flow that arises from normal operations such as revenues and cash operating expenses net of taxes. 

This includes: 

Cash inflow (+)

1. Revenue from sale of goods and services2. Interest (from debt instruments of other entities)3. Dividends (from equities of other entities)

Cash outflow (-)

1. Payments to suppliers2. Payments to employees3. Payments to government4. Payments to lenders5. Payments for other expenses

2. Cash Flow from Investing Activities (CFI)CFI is cash flow that arises from investment activities such as the acquisition or disposition of current and fixed assets.

This includes: 

Cash inflow (+)

1. Sale of property, plant and equipment2. Sale of debt or equity securities (other entities)3. Collection of principal on loans to other entities

Cash outflow (-)

1. Purchase of property, plant and equipment2. Purchase of debt or equity securities (other entities)3. Lending to other entities

3. Cash flow from financing activities (CFF)CFF is cash flow that arises from raising (or decreasing) cash through the issuance (or retraction) of additional shares, or through short-term or long-term debt for the company's operations. This includes:

Cash inflow (+)

1. Sale of equity securities2. Issuance of debt securities

Cash outflow (-)

1. Dividends to shareholders2. Redemption of long-term debt3. Redemption of capital stock

A cash flow statement looks like this:

Reporting Non-Cash Investing and Financing TransactionsInformation for the preparation of the statement of cash flow is derived from three sources: 

1. Comparative balance sheets2. Current income statements3. Selected transaction data (footnotes)

Some investing and financing activities do not flow through the statement of cash flow because they do not require the use of cash.

Examples Include:

Conversion of debt to equity Conversion of preferred equity to common equity

Acquisition of assets through capital leases Acquisition of long-term assets by issuing notes payable Acquisition of non-cash assets (patents, licenses) in exchange for

shares or debt securities

Though these items are typically not included in the statement of cash flow, they can be found as footnotes to the financial statements.

Find out why EV/EBITDA is better than price to earnings ratioSameer Bhardwaj, ET Bureau Jan 20, 2014, 08.00AM IST

Tags: Shares | Insurability | Embedded Value | depreciation

(The ratio has two components:…)

Financial analysts employ several valuation ratios for analysing and identifying over- and undervalued stocks. Most research reports concentrate on the application of such valuation ratios and say very little about the rudiments.

It is important for small investors to understand the basics of such ratios as these can help them analyse the stocks more effectively.

In the first part of the series on understanding financial ratios, we look at the EV/EBITDA ratio, which is preferred by some analysts over the price to earnings or PE ratio.

HOW TO CALCULATE THE RATIOThis ratio has two components: EV and EBITDA. EV, or enterprise value, is calculated by adding the market value of equity and debt, and subtracting the cash holding as shown in the firm's book of accounts. It gives the cost of acquiring business, as the buyer needs to pay the market value of equity or market capitalisation while purchasing the company. However, the cash with the firm acts as a cushion for the buyer and needs to be deducted.

The value of debt must also be included while estimating the acquisition cost since the interest cost on debt can affect the firm's future cash flow and the principal is repayable on maturity.

The other part of the metric is the EBITDA, which is also known as the operating profit. EBITDA is the earning before interest cost, tax, depreciation and amortisation, and appears in the firm's income

statement. The other way of arriving at EBITDA is by adding depreciation, interest cost and tax to the net earning.

Comparing the firm's performance based on net earning leads to a bias due to differences in accounting policies and capital structures. This is because some firms may charge depreciation on an accelerated basis, which leads to high depreciation costs in the initial years.

In addition, some firms have a high debt in their capital structure leading to high interest costs. Such depreciation and interest costs ultimately depress the net earnings. EBITDA discards such difficulties due to varying depreciation policies and debt-equity mix. This measure of earning is also sometimes used as a proxy for cash flow as it adds the non-cash expenditure (depreciation).

HOW IT DIFFERS FROM PE RATIOThe PE ratio measures the money that investors are willing to pay for every rupee a company earns. It is a metric used for valuing the firm's equity as it takes into account the residual earning available to equity shareholders.

Though widely used, PE ratio has its limitations as it cannot be used for valuing lossmaking companies and fails to overcome the distortions caused by different accounting policies and capital structures.

The EV/EBITDA ratio is better as it values the worth of the entire company. PE ratio gives the equity multiple, whereas EV/EBITDA gives the firm multiple. The latter is based on the notion of most successful investors, who propose that equity investing is not just buying/selling shares, but buying/selling the business.  WHAT THE RATIO MEANSThe division of EV by EBITDA gives a good measure of value. It estimates the number of years in which the business will repay its acquisition cost to the buyer through its earnings. For example, if one is interested in buying a firm at an EV of Rs 1,000 crore and its annual earning (EBITDA) is Rs 200 crore, the firm will repay its entire acquisition cost to the buyer in cash in just five years.

Generally, the lower the ratio, the better it is. The ratio helps determine the true earning potential of the business. It is ideal for valuing telecommunication and cement & steel companies as these carry a high debt in their balance sheets and have high gestation periods.

The ratio proves a great tool for valuing companies that are making losses at the net earning level, but are profitable at the EBITDA level. However, the ratio is harder to calculate as it requires several adjustments in the net income.

Also, EV value is not readily available and has to be derived from the firm's financial statements. Estimating the true market value of debt is also not easy as it is influenced by changes in interest rates.

This post was prompted by a minor change in the standard Bloomberg

company description which I noticed over the last view months. If one

uses the function “DES” Bloomberg provides on page 3 some standard

ratios which are quite helpful in order to get a first view on a company.

Within the screen there are 6 boxes, the upper left box showing currently

the following ratios (example: National Oilwell Varco, NOV US):

Issue Data

~ Last Px USD/80.91

~ P/E 14.4

~ Dvd Ind Yld 1.3%

* P/B 1.60

~ P/S 1.5

~ Curr EV/T12M EBIT 8.6

~ Mkt Cap 34,637.6M

~ Curr EV 35,743.6M

Interestingly, a few weeks ago (??), one would get EV/EBITDA instead of

EV/EBIT. I am not sure why they changed it, but it is a good starter in

order to think about the differences between P/E, EV/EBITDA and EV/EBIT

The P/E ratio

The P/E ratio is clearly the most famous valuation ratio. A low P/E strategy

still seems to work. In my opinion, the P/E ratio clearly has two major

fundamental drawbacks as a “strong” criteria for me as a stock picker:

– it does not reflect net debt or net cash

– under IFRS, many items (Pensions, currency changes) are booked

directly into equity. This is the reason why I prefer P/Comprehensive

income

EV/EBITDA Ratio

The “classic” EV/EBITDA ratio is much better in capturing debt and net

cash than the P/E. As I have explainedin an earlier post, one should be

careful with EV in certain cases (leases, pensions), but overall, EV is much

better to compare highly leveraged companies with “conservative”

companies

EBITDA, as the name says, is

“Earnings before Interest, Taxes, Depriciation and Amortization”. Some

people have called it “Earnings before everything else” but in theory,

EBITDA should be a proxy for operating cashflow.

As I have written before, this metric has been used a lot by Private equity

buyers in order to assess, how much debt could be pushed into a

company unitl it chokes.

In the latest edition of O’Shaugnessey’s “What works on Wall Street”,

EV/EBITDA is also one of the strongest single factors, much better than

P/B and P/E.

The problem with EBITDA is that although it might approximate Operating

Cashflow, it does not equal “free cashflow”. The “D” in EBITDA means

depreciation. If you leave out depreciation, the effect will be that capital-

intensive businesses which need a lot of capex (and depreciation) look

suddenly quite good, although this cashflow never reaches the equity

holder, because it is necessary to maintain the productive capital.

We can see this easily if we look at the DAX companies, sorted by

EV/EBITDA:

EV/EBITDA T12M

Deutsche Lufthansa AG 3.26

RWE AG 3.51

K+S AG 4.33

Continental AG 4.78

E.ON SE 4.80

Deutsche Telekom AG 5.85

ThyssenKrupp AG 6.27

HeidelbergCement AG 6.82

Volkswagen AG 6.93

LANXESS AG 7.25

Bayerische Motoren Werke AG 7.26

Deutsche Post AG 8.19

Infineon Technologies AG 8.19

Fresenius SE & Co KGaA 8.74

BASF SE 8.82

Bayer AG 8.97

Linde AG 9.10

Merck KGaA 9.12

Fresenius Medical Care AG & Co KGaA 10.33

Siemens AG 11.05

Henkel AG & Co KGaA 11.46

Adidas AG 11.85

Daimler AG 11.86

Deutsche Boerse AG 13.64

SAP AG 13.93

Beiersdorf AG 15.59

The cheap stocks are those companies, which are REALLY capital-

intensive. Clearly, RWE and EON need to continuously reinvest into their

huge power stations or they will not be able to produce any electricity

soon. On the other hand, Deutsch Börse is basically a market making

software with some computers and a government license. Very few

assets, small depreciation.

So the “difference” between low EV/EBITDA and HIGH EV/EBITDA is not

necessarily “cheapness” but different levels of capital intensity

EV/EBIT

This is why many “professionals” prefer EV/EBIT to EV/EBITDA. EBIT

already deduces depreciation and should therefore be a better proxy

for Free cashflow than EBITDA.

Let’s look at the Dax companies sorted by EV/EBIT:

EV/T12M EBIT EV/EBITDA T12M

SDF GY Equity 5.7 4.3

CON GY Equity 7.5 4.8

EOAN GY Equity 7.5 4.8

RWE GY Equity 7.9 3.5

FRE GY Equity 11.2 8.7

HEI GY Equity 11.2 6.8

TKA GY Equity 11.3 6.3

DPW GY Equity 12.3 8.2

BAYN GY Equity 12.7 9.0

BAS GY Equity 13.0 8.8

FME GY Equity 13.4 10.3

HEN3 GY Equity 13.6 11.5

LXS GY Equity 13.6 7.3

BMW GY Equity 13.9 7.3

DTE GY Equity 14.3 5.8

DB1 GY Equity 15.8 13.6

VOW3 GY Equity 16.0 6.9

SIE GY Equity 16.2 11.0

LHA GY Equity 16.2 3.3

MRK GY Equity 16.6 9.1

LIN GY Equity 16.7 9.1

SAP GY Equity 17.0 13.9

BEI GY Equity 18.3 15.6

ADS GY Equity 18.6 11.9

DAI GY Equity 19.2 11.9

IFX GY Equity 22.5 8.2

 

avg 13.9 8.5

I have added also EV/EBITDA and P/E in this table. It is interesting

that P/Es look rather random when we sort by EV/EBIT. Especially

Lufthansa looks now really expensive as well as Daimler and Infineon. On

the other hand, a relatively expensive looking stock like Fresenius now

looks rather cheap. A company like Beiersdorf looks expensive in any

metric and th utilities look still cheap but not Deutsch TeleKom.

For the utility stocks for instance I think EV is too low, because one needs

to add the liabilities for decommissioning the Nuclear plants to EV.

A quick word on Free Cash flow and P/Free cashflow ratio

As I have written earlier, one really has to be carefull with reported free

cash flows. Cashflow statement are not really audited and it is quite easy

to “massage” the categories. Free cash flow is clearly an important

number to look at in a second step, but as a standard indicator it has very

limited use in my opinion.

Some additional pitfalls

Using EV/EBITDA and EV/EBIT smoetimes can also be tricky. Among others

are operating leases, pensions, certain prepayments etc. which can

change EV dramatically. But there can also be issues on the EBIT/EBITDA

side:

For instance, those are the stats for Statoil ASA, the Norwegian Oil

company:

P/E 11.8

EV/EBITDA 2.2

EV/EBIT 3.3

From an EVEBit perspective, this clearly looks like a no brainer: we only

pay 3 times EBIT for a rock solid oil and gas company. Well, but we might

have forgotten one important thing: Between EBIT and Free cash flow we

have still two other items: Interest and Taxes.

As Statoil doesn’t pay much interest (only 2% of EBIT) the issues is clearly

taxes. Statoil is subject to special taxes, which on average amount to

75% of EBIT. There might be some leeway to shelter certain tax

payments, but in a country like Norway the companies will have to pay

most of those taxes in cash.

Interest and Taxes are especially important if one compares companies

across different countries. All other things equal, companies in high tax

rate countries with high taxes will trade at lower EV/EBIT and EV/EBITDA

multiples than in low tax low-interest rate countries. So fo instacne the

Swiss MArket Index trades at 16.7 x EBIT and 12.2 EBITDA significantly

higher than the German index. At least part of that is due to the much

lower tax rate in Switzerland and even lower interest rates.

So a comparison of peer companies across countries with very different

tax rates ind interest rates should not solely be based on EV/EBIT or

EV/EBITDA.

Other issues with EV/EBIT and EV/EBITDA – financial companies

and financing business

EV measures usually don’t work well with financial companies and also

companies which have a lot of financing business on their books.

Originally, EV is meant to capture “real” leverage, i.e. debt issued to pay

for machinery, inventory etc. Debt issued to fund for instance client

purchases is referred to as “operating” leverage. It is a little bit a grey

area. Clearly, one should prefer a company which sells only stuff against

cash than financing it for several years. The financial crisis in 2008 has

shown that such “operating” leverage quickly became “strategic” if the

roll over doesn’t work. On the other hand, in normal times operating

leverage could be potentially adjusted against EV as you have “extra

assets”.

If one tries to compare financial companies vs. industrial companies

though, P/E is clearly more useful, as financial companies per definition

have much higher EVs than non-financial companies.

Price /Comprehensive income

This is a ratio which I use especially for financial companies.

Comprehensive income inlcudes all kind of “value changes” which are

booked directly against equity, such as changes in the value of pension

libailities, value changes of financial assets including hedges, currency

translations etc. Especially for financial companies, comprehensive

income is a pretty good leading indicator although it is rarely used in

my experience.

Summary:

In general, I would recommend to look at all “Popular” ratios in parallel,

because it gives a better “multi dimensional” view on a company. For

“Normal” company, in my opinion, EV/EBIT is the most significant ratio,

followed by P/Comprehensive Income.

P/Es and Ev/EBITDA are clearly also helpful. The most interesting cases

are those, where the different ratios are completely different. This is often

an indicator for somthing “special” going on and potentially a stock to

investigate further.

In any case, although I like EV/EBIT, one should always “look down” in the

P/L to the real bottom line (comprehenive income) as good CFOs are

quite creative in moving expenses “down” the chain where many people

don’t bother to look any more.

Finally as a special service, an overview over the different ratios and when

to use them: