»5 Minute Wrap Up by Equitymaster

On This Day - 24 FEBRUARY 2011
Are you using this wrong valuation method?

In this issue:
» This is why US is not falling against other currencies
» Morgan Stanley sounds warning bells on global economy
» PE funds turn to restaurant chains in India
» India's trade deficit trend unsustainable
» ...and more!

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EV/EBITDA. No other valuation metric has been embraced as widely as this one in recent times. In fact, this metric has perhaps even overpowered other popular ratios like price to book value and price to cash flow.

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.

What do you think? Do you think EV/EBITDA is the right valuation metric? Share your views with us or comment on our Facebook page.

 Chart of the day
Here's another reason why we think realty prices could soften in Indian metros in the near term. Today's chart of the day shows the real estate inventory in terms of number of months as of Dec 2010 across various metros. As one can make out, inventories in all the metros mentioned in the chart stand way higher than what is considered to be normal. The worst hit seems to be Hyderabad where the current Telangana standoff has led to people postponing their buying decision and hence, resulting into inventory to the tune of more than 28 months. Mumbai too isn't far behind.

Source: LiveMint

The money printing exercises (quantitative easing is a more sophisticated term) of the US Fed have received tonnes of eggs and rotten tomatoes. Mr. Bernanke, the face of currency manipulation, has become quite a favourite punching bag for most economic think tanks. Of course, he's sitting atop a giant economy that has a grave influence on the rest of the globe. Nobody would have cared much if he was heading the central bank of the Republic of Nauru.

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".

Unrest in the MENA region has caused oil prices to rally 9.2% over the past four weeks. Crude has once again reached dreaded 3 digit levels of US$ 100/barrel. Political unrest has been plaguing the region where the black gold is concentrated. Countries right from Tunisia to Iran have been affected. According to Morgan Stanley, the global economy may slip back into a recession if oil prices rise by another US$ 20-30. The world is still in the process of recovery from the worst recession in more than 50 years. If fuel prices sustain at these high levels, it could send the patient back to the emergency room.

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.

What is the most popular thing we Indians do when we want to celebrate? We got out to a restaurant for a meal. So it would not come as a surprise that when personal incomes of the people grow, the business that would benefit most is the restaurant business. This is why the private equity (PE) funds are now looking at investments in restaurant chains.

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.

As if problems on the inflation front were not enough, the Indian government has another serious issue to contend with notable widening trade deficit. The fear is that the trade deficit could more than double to US$ 278.5 bn in three years and may cause an unsustainable current account deficit. In other words, it could widen to 12.8% of GDP by 2014 from 7.2% in this fiscal year. The obvious solution is to ensure that exports grow at a faster rate than imports and that the latter is curtailed. But that is easier said than done. For starters, oil imports account for a significant portion of the import bill. And firmer trends in crude prices are hardly going to do much in terms of bringing this down. Trade officials have hinted that reducing imports of farm products and coal could bring the deficit to manageable levels. But with India's coal quality being poor, we are not sure how that can be achieved.

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.

Meanwhile, the indices continued to sink deeper and deeper into the negative territory with each passing hour today. At the time of writing this, the BSE Sensex had shaved off a huge 470 points from its yesterday's closing. Banking heavyweights were yet again seen exerting the maximum pressure. The mood across rest of the Asian indices wasn't buoyant either as most of them closed in the red. Europe too has opened on a negative note.

 Todays investing mantra
"Timidity prompted by past failures causes investors to miss the most important bull markets." - Walter Schloss

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