There are 3,500 publicly traded companies in the U.S. alone, and all of their stock prices are constantly changing. Typically, our portfolio consists of less than 10 stocks. In order to narrow down the universe of potential investments, we begin our search process by looking at those companies trading at the lowest multiples of earnings. There are a few commonly used multiples, each with their advantages and disadvantages, the most commonplace being P/E.
However, for the starting point of our analysis, we prefer to use EV/EBIT because it allows for easier comparison of businesses with disparate capital structures. Actually, we invert the metric and think about it in terms of EBIT/EV, which equates to the pre-tax earnings yield that would accrue to the owner of the entire enterprise on an unlevered basis. We believe this is the most sensible starting point.
We think about buying an ownership interest in a publicly traded company in much the same way one might think about buying a rental property. The first thing you would probably think about is how much rental income would be left after all expenses and then compare that to the purchase price. In real estate, this is referred to as the cap rate, and it is the most common metric for the yield on a property. Cap rate and EBIT/EV are virtually equivalent. We see no reason why a business should be valued differently from any other income-producing asset, and we believe this is the way that most private investors think as well.
One might argue that EBIT/EV is an abstraction, and that investing on the basis of a capital structure that does not actually exist is nonsense; as such, P/E would be more appropriate. There is some truth to this view. However, there are two main reasons we form our analysis primarily around EBIT/EV.
First, as stated above, we believe that most private investors, including private equity investors think in terms of EBIT/EV. As such, if there were a more appropriate capital structure for a business, someone is likely to come along and buy the business in order to capitalize it properly, which would necessarily involve a premium to the current stock price.
Secondly, we believe that, by starting with P/E, one runs the risk of finding highly-leveraged businesses more attractive than they really are. If you are going out and buying those stocks with the lowest P/Es, you are very likely to end up owning a basket of stocks with significant debt and declining earnings – a dangerous combination. By starting with EBIT/EV, however, you are more likely to end up with an assortment of capital structures.
It is true that some businesses can support more debt than others, and that is a factor that cannot be ignored when valuing a business. Tax rates too, which were not touched on for the sake of brevity, must be considered. With that being said, we believe that EBIT/EV most closely aligns with our view that stocks are ownership shares in business.