The earnings yield is half of the “Magic Formula” popularized by Joel Greenblatt. This EV ratio is similar to the more popular price to earnings ratio (P/E ratio) but with two important differences. First, Greenblatt uses enterprise value instead of market capitalization. Second, he uses Earnings Before Interest & Taxes (EBIT) instead of earnings. These two changes allow the analyst to contrast companies with different capital structures on an equal basis by removing the biases of debt and cash.
Tobias Carlisle, in his book Deep Value does an outstanding job of dissecting the magic formula (pages 58- 69) and explaining how the earnings yield (a.k.a the enterprise multiple) is an exceptional value investing ratio.
2. EV/EBITDA
EV/EBITDA = Enterprise Value / Earnings Before Interest Taxes Depreciation & Amortization
(When comparing similar companies, a lower enterprise multiple would be a better value or bargain than a higher multiple.)
or turn it around to get the yield…
EBITDA Earnings Yield = Earnings Before Interest Taxes Depreciation & Amortization / Enterprise Value (EBITDA/EV)
(When comparing similar companies, a higher earnings yield would indicate a better value or bargain that a lower yield.)
Example: Company XYZ has an enterprise value of 5 billion and an EBITDA of 650 million.
EV/EBITDA = $5,000,000,000 / 650,000,000 = 7.7 multiple
EBITDA/EV = $650,000,000 / $5,000,000,000 = 13% yield
3. EV/CFO
EV/CFO = Enterprise Value / Cash From Operations
EV/CFO = Market Capitalization + Total Debt – Cash / Operating Income (Revenue – Cost of Sales) + Depreciation & Amortization – Taxes +/- Change in Working Capital
(When comparing similar companies a lower multiple would be a better value or bargain than a higher multiple.)
or turn the ratio around to get the yield…
Cash Flow From Operations Yield = Cash Flow From Operations / Enterprise Value (CFO / EV)
(When comparing similar companies a higher CFO / EV yield would indicate a better value or bargain than a lower yield.)
Example: Company XYZ has an enterprise value of 5 billion and CFO of 600 million.
EV/CFO = 5,000,000,000 / 600,000,000 = 8.3 multiple
CFO/EV = 600,000,000 / 5,000,000,000 = 12% yield
Cash Flow From Operations (CFO) is a better valuation metric than profits because it is unaffected by accounting entries such as depreciation and amortization, or cash flows from financing or investing activities.
The EV/CFO ratio will tell you how many years it would take to buy the entire company if you could use all the cash from operations for the purchase.
(Note: For analysis of most companies I use the CFO definition that includes interest as an operations expense and therefore a reduction in cash from operations.)
4. EV/FCF
EV/FCF = Enterprise Value / Free Cash Flow
(When comparing similar companies, a lower enterprise multiple would be a better value or bargain than a higher multiple.)
or turn it around to get the yield…
Free Cash Flow Yield = Free Cash Flow / Enterprise Value (FCF/EV)
(When comparing similar companies, a higher earnings yield would indicate a better value or bargain than a lower yield.)
The next two ratios would be secondary in importance to the above ratios. That doesn’t mean they are not useful. It just means they would usually be used in limited situations or when an analyst wants even deeper value comparisons between companies:
5. EV/Sales
EV/Sales = Enterprise Value / Sales (Revenues)
The EV/Sales ratio provides the analyst the relationship between sales and the cost of buying the company. In other words, it tells you the total cost of buying the company sales.
6. EV/Assets
EV/Assets = Enterprise Value / Assets
For the investor looking for cheap assets, the EV/Assets ratio provides an additional metric with which to look for bargains.
Conclusion
Enterprise value is a key metric for value investors because it best represents the total value of a company and is capital structure neutral. EV can be used for calculating enterprise value ratios that provide important comparisons between companies.
Related Reading:
I am a seasoned financial analyst with a deep understanding of value investing metrics, particularly those popularized by experts like Joel Greenblatt and Tobias Carlisle. My expertise extends to dissecting financial ratios and utilizing them for effective investment analysis. Now, let's delve into the concepts mentioned in the article:
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Earnings Yield (Enterprise Multiple):
- The earnings yield, half of the "Magic Formula," is emphasized by Joel Greenblatt.
- It uses Enterprise Value (EV) instead of market capitalization and Earnings Before Interest & Taxes (EBIT) instead of regular earnings.
- This adjustment allows for a more equitable comparison of companies with different capital structures, eliminating biases from debt and cash.
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EV/EBITDA (Enterprise Value to Earnings Before Interest Taxes Depreciation & Amortization):
- EV/EBITDA is a ratio that compares Enterprise Value to EBITDA, providing insights into a company's valuation.
- A lower enterprise multiple indicates a better value, and conversely, a higher multiple suggests a higher valuation.
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EV/CFO (Enterprise Value to Cash From Operations):
- EV/CFO compares Enterprise Value to Cash From Operations and is considered a valuable valuation metric.
- It includes Market Capitalization, Total Debt, and Cash in its calculation.
- CFO is preferred over profits as it is unaffected by accounting entries and provides a clearer picture of a company's financial health.
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EV/FCF (Enterprise Value to Free Cash Flow):
- EV/FCF compares Enterprise Value to Free Cash Flow, offering insights into a company's value.
- A lower enterprise multiple is considered better, while a higher Free Cash Flow Yield indicates a better value.
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EV/Sales (Enterprise Value to Sales):
- EV/Sales ratio relates Enterprise Value to Sales (Revenues), indicating the total cost of buying the company's sales.
- It helps in understanding the relationship between sales and the cost of acquiring the company.
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EV/Assets (Enterprise Value to Assets):
- EV/Assets ratio is used to find bargains for investors seeking cheap assets.
- It relates Enterprise Value to a company's total assets, providing an additional metric for value comparison.
Conclusion:
- Enterprise Value is a crucial metric for value investors as it represents the total value of a company and is neutral to capital structure.
- The mentioned ratios provide valuable comparisons between companies, aiding investors in making informed decisions based on various financial perspectives.
