With interest rates staying high, we should incorporate debt into valuations

And that means using Enterprise Value

A Price Earnings multiple tells you how many years it would take to recoup your investment if earnings are stable and all paid out as dividends

Pretend you own a business that earns 100 a year and you sell it to me for 500

The PE of 5 means I’d recoup my investment in 5 years at constant earnings

BUT

What if you had 200 of surplus cash in the bank?

My “effective price” is 300 because I’d recoup 200 on day 1

Meaning a 3-year payback

But what if you had 400 of debt?

I’d spend the 1st 4 years repaying the loan

and then 5 years recouping my investment so my effective price is 900

This “effective price” is called “Enterprise Value”

Market cap + debt – cash

Purists argue that you can’t use EV/Earnings instead of Price/Earnings because earnings is after interest so you’d be double counting the debt – adding the debt balance to the numerator and deducting the interest expense from the denominator

So they use earnings BEFORE interest

and thought, while we’re at it… let’s also exclude:

-Tax (surely the cost of profitable businesses..?)
-Depreciation (surely the real cost of your capex spread over time?)
-Amortisation (surely a real cost of paying for goodwill?)

And that’s how they arrived at EV/EBITDA

But I’d chase away any analyst who tried to sell me something using EBITDA

And I don’t care that “everyone uses it”,

It’s nonsense and Warren Buffett says so too!

Useful for comparison but NOT for valuation (IMHO)

I get the point about interest, although I think companies with huge debt loads should be doubly punished… but I take a firm line at excluding D & A

Therefore let’s run with EV/Operating income as a means of comparing valuations across regions

We’ll exclude financials because it’s messy with depositors’ cash etc.

Averages can get skewed by a few large outliers so given the population size, let’s rather use medians

S&P500                              21x
Europe 600                        19x
Topix 500                           15x
Topix Small (500)             11x

Is large-cap US twice as expensive as small-cap Japan?

Well let’s drill down

Take the Top 10 in the S&P500 (what most people own), and the average jumps to 43x, median of 27x

Microsoft 27, Amazon 78, Nvidia 94, Tesla 61, Eli Lilly 80..

But the conventional EV calculation also doesn’t exclude Long-term investments in the same way as it excludes cash

And many Japanese companies have listed investments that we could also recoup on day 1..

Exclude these and the average for the Topix Small drops to 10x

Take the lowest quartile of Japanese Small caps

and it drops to 5x

Compared to 43x for the Top 10 in US…

Almost 10 times cheaper!

In a big world, there are always opportunities

but they usually aren’t where everyone is looking

“You can’t buy what is popular and do well” WB