Streetwise for Friday, May 12, 2017
Regular readers of this column know that I espouse dividends as a key factor to consider when evaluating a possible equity investment because over time companies that consistently raise dividends tend to outperform the market.
However, dividends should not be used alone. You need to utilize one or more of the financial ratios that incorporate earnings and/or earnings growth. Those two factors are the hallmark of any corporation. And as important as dividends are, they are not possible without earnings and earnings growth.
For example, one important but underutilized ratio is the enterprise multiple. It measures a company’s valuation based on the ratio of its enterprise value (EV) to earnings before interest and taxes or EBIT. In my opinion this ratio is preferable to the more common ratio of market capitalization (share price multiplied by the number of shares outstanding) divided by net earnings.
Whereas market capitalization is the equity value of a business, the enterprise value includes not only equity but also debt less cash. It can be thought of as the cost to acquire a company.
In other words, EV/EBIT answers the question, “What is the value of a company per each dollar of EBIT?” A high (low) EV/EBIT means the company is potentially overvalued (undervalued).
Using EBIT in place of net earnings provides a clearer picture of a company’s operating profits. By not including interest or taxes, the metric compares the operational structure of the business, rather than letting a company’s financing and tax statuses affect its profitability.
Enterprise ratios are often used by analysts to quickly ascertain and compare potential corporate valuations. All things being equal, the lower a ratio such as EV/EBIT is, the better.
Consider for example American Airlines(AAL). Berkshire Hathaway, i.e., Warren Buffett, recently raised its stake in American during the first quarter of this year. Berkshire now owns 49,278,854 shares or 10.2 percent of the American.
The enterprise value of American is $40.86 billion, with an EBIT number of $5.29 billion. Dividing EV/EBIT yields and enterprise multiple of 7.72. Is this a good ratio or a bad ratio? Obviously, Buffett must like it.
However, as with any financial ratio or number, a single value is of minimal use. To forecast accurately, you need to establish a trend over a 3 to 5-year period and then compare the numbers against those of companies in similar businesses.
Looking at Delta Airlines (DAL), the enterprise value is $42.25 billion and EBIT is $7.024 billion, producing an enterprise multiple of 6.44, a number that is smaller, and theoretically better, than that of American. Keep in mind that Buffett just reduced his stake in Delta, although it is still substantial, to 55,025,995 shares or a 7.6 percent ownership.
Another helpful parameter is a below average capitalization ratio. This ratio compares long-term debt to the sum of long-term debt and shareholder equity. A general guideline is a ratio of less than 30 percent.
For American, long-term debt is $22.489 billion, while shareholder equity is $3.785 billion, yielding a capitalization ratio of 14.4 percent. Delta’s long-term debt is $6.201 billion, while shareholder equity is $12.287 billion. The capitalization ratio is 33.5 percent. Now see if you can replicate some of the rationale behind Buffett’s decision.
Screening simply separates the wheat from the chaff. Your final selection process needs to utilize subjective factors such as management strength, franchise in the marketplace, potential earnings and dividend growth.
Note to Readers: Rudd International has sponsored a Superhero Puppy sculpture to raise funds for Southeastern Guide Dogs. The unveiling will take place on May 24th at The Met on St. Armand’s Circle, 5:30 to 7:00 P.M. If you would like to meet the artists and friends of Southeastern Guide Dogs, please RSVP Fran Marinaro at firstname.lastname@example.org or at 941-400-7884. You can vote for your favorite sculpture, $1.00 per vote, with all funds going to Southeastern Guide Dogs.
Lauren Rudd is a financial writer and columnist. You can write to him at LVERudd@aol.com. Phone calls accepted between 9 AM and 3 PM at (941) 706-3449. For back columns please go to www.RuddReport.com.