In this post, we continue our series of exploring some common checklist considerations:
Profitability and Strength
Earnings before interest and taxation is probably the simplest way to assess a business’s profitability. We suggest including depreciation & amortisation as a real cost because, although it might be discretionary spend year to year, unless you are very confident the depreciation and amortisation is very ‘fast’ or the assets will last indefinitely those costs are real – they will require cash investment at some point. Therefore, we aim to review EBIT as it strips out any debt or capital structure nuances or anomalies. Very simply, the higher the better, both in absolute terms and relative to peers!
- Return on [SOMETHING]
Return on capital or equity or assets is a difficult metric to get confident with. What we are trying to assess is both a business’s overall profitability vs capital employed but also how quickly it can grow. A very large business with a lot of capital making small margins (think Sainsburys/Tescos) is good in some respect (high barriers to entry) but is also a difficult business to grow as it will consume a lot of cash. In contrast, a software business with little capital employed making 20% operating margins suggests a highly efficient use of capital and an ability to scale without raising huge amounts of capital. Generally, a high return on capital is regarded as an indicator for a better business model.
- Gross margin
Another metric we suggest looking at is gross margin. The challenge with investing is establishing which businesses have the best moats and which don’t. A good moat usually means pricing power, and a good gross margin implies pricing power. Its not always the case, but at Journal.investments we like this metric because its simple and difficult to distort and, combined with others, gives an indication of a business’s moat.
- EBIT to EV
We have already discussed EBIT above, but some explanation of EV. EV is equity value, plus debt, minus cash. Using only market cap ignores the level of debt in a business. Often the level of debt in a business is many times lower than its equity value, particularly for high growth companies. However, to neglect its inclusion in valuations is careless. So, looking at EBIT to EV provides a useful proxy for both absolute cheapness (eg less than 4 or 5x) and relative cheapness vs peers and the market.
We have to mention PE given its ubiquity. However, we are not fans beyond a relative application. Price to earnings measures the price per share vs the earnings per share of a stock. It ignores the capital structure (eg the level of debt) and the capital structure implied in the earnings. This is ok for a stable business with a standard capital structure, but useless in the extremes and probably a bit of a sledgehammer. We would always suggest moving beyond this metric and probably only applying on a relative basis.
There are so many valuation metrics out there. Individuals will have their favourites but also, and more importantly, certain sectors require specialist or particular metrics to understand them. Notables include property REITs (asset to liability valuations), hyper active software rollups (forecast / pro forma earnings to EV) and even the size at which you invest (larger groups working on relative valuations and smaller businesses on absolute).