|»5 Minute Wrap Up by Equitymaster|
On This Day - 24 FEBRUARY 2011
Are you using this wrong valuation method?
In this issue:
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EV/EBITDA, its supporters argue, enables one to get a better picture of a firm's cash flow. If the firm under question is leveraged and has only recently done a lot of capex, then other measures like P/E could end up conducting a wrong diagnosis of the firm. In view of this, EV/EBITDA is a better metric than P/E, conclude the former's supporters. We would certainly not disagree. In cases such as these, EV/EBITDA could prove to be more reliable than say P/E.
However, we believe that in most cases where EV/EBITDA is applied, it is applied for the wrong reasons. It is applied to dress up a financial statement. A lot of companies out there have consistently high D/E ratios. Besides, they also undertake heavy capex every year. In such firms, interest and depreciation expenses are thus real expenses and hence, cannot be ignored under the garb of EV/EBITDA.
Using a P/E ratio in combination with a D/E ratio is a far better thing to do we believe avoid a firm with a high D/E ratio rather than try to find out its EV/EBITDA multiple and hence, make the mistake of investing in it if the same is low. Furthermore, a firm with a continuously high maintenance capex can no longer hide its true economics if a P/E ratio is used.
Lastly, it will be pertinent to add what Warren Buffett said on the issue. He once mentioned that people who use EBITDA are either trying to con themselves or are conning the investors. Interest and taxes for some sectors are real costs as per Buffett and hence, should be subtracted from revenues to get a correct picture of the true economics of a firm.
Now the interesting part... Gold will tell you that the US dollar has lost a significant chunk of its value. Why then, has the green back not fallen in relation to other international currencies? In fact, it even rallies against them at times. Isn't this very counterintuitive?
Alright, we'll tell you the truth now. The US Fed is not the only one printing money recklessly. It's happening in the European Union. UK is doing it. Japan and China are also doing the same. And quite proudly, India is part of this elite group as well. A mere look at the rate at which money supply in these economies has sky-rocketed is mindboggling.
So where are we headed? It looks like the making of yet another global economic nightmare. How is it going to affect us? Well, it is already hurting us. Inflation it is! And there is every sign that it could get worse. Paper money is not at all safe given the way central bankers are manipulating it. And no wonder investors are all scrambling for hard assets like gold, silver and other such "real currencies".
US Treasury Secretary, Timothy Geithner, on the other hand believes the world is now more able to withstand increases in oil prices. He believes that central banks are better equipped in dealing with such a crisis. Morgan Stanley however, noted that an 85-90% increase in the oil prices over a single year was followed by recessions in the US. This happened in 1975, 1980, 1990, 2000 and 2008. Higher fuel prices hurt consumers' wallets, shrink corporate profit margins and force central banks to hike rates. This in turn causes economic growth to slow down. Maybe Geithner could do with some lessons in history and economics.
The industry has witnessed an infusion of almost US$ 375 m from the PE funds. Though the number of deals remains small at 8, the size of deals has been growing. The reason for this is the low penetration rates for branded hotel and restaurant industry, which will grow with growing consumerism in the country. As a result, the PE funds look at this area as a high growth, high return possibility. The organized branded restaurant industry in India has been growing at an annual rate of nearly 20%. And it currently accounts for just 20% of the total restaurant industry of the country. At this rate, looks like this business will definitely drive lucrative returns for the PE funds.
The problem is that if the trade deficit keeps ballooning, India will have to depend a lot on capital inflows to plug the current account deficit gap. That is dangerous especially in times of uncertainty when the country could all of a sudden be subject to huge capital outflows. Indeed, these are serious soul searching times for the government.
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