How Do We Know When a Stock is Truly Cheap?

 Executive Summary

  • Valuation metrics are a central element of Heartland’s 10 Principles of Value Investing™.
  • Additional analysis using EV/EBITDA allows investment managers to evaluate companies in much the same way private equity investors do.
  • In our view, EV/EBITDA is a useful complement to traditional valuation measures like Price/Earnings, Price/Book, and Price/Cash Flow.
When considering valuation-conscious investing, often the first metric that comes to mind is price/earnings, or P/E. This fundamental measure of value identifies stocks whose share prices are moderate relative to the level of profitability the company is able to record. 
Heartland’s investment process, however, is designed to measure valuations from multiple angles in an attempt to screen out outliers that appear cheap based on a single multiple. In addition to our fundamental, company-specific research into an organization’s management, business model, financial soundness, and potential catalysts, we employ a number of valuation metrics to size up a potential addition to a portfolio. In this article we’d like to discuss one of the less–understood valuation measures, the Enterprise Multiple, often expressed as EV/EBITDA.

Understanding the EV/EBITDA Calculation

As the length of the name implies, EV/EBITDA involves a few more elements than P/E:

Enterprise Value (EV) = Market Capitalization + Debt and other liabilities – Cash and Cash Equivalents

EBITDA = Earnings Before Interest, Tax, Depreciation, and Amortization

By incorporating both the debt a company has incurred and the cash it has on hand, Enterprise Value reflects a company’s assets as well as its liabilities, and suggests the approximate price it would take to acquire the company as a whole. The price used in establishing a P/E ratio, in contrast, simply indicates the company’s share price.

Similarly, while the earnings figure used in P/E is calculated after all expenses, cash and non–cash, are deducted, EBITDA reflects the actual cash flow a company generates from operations. Thus it provides a somewhat different perspective.

To get a picture of just how EV/EBITDA helps to clarify whether a company genuinely represents an attractive value, let’s consider an example we encountered recently of two firms—both are players in the aerospace industry. KLX Inc. (KLXI) distributes fasteners and consumables used in aerospace. Additionally, the company has an energy services group, which provides services and equipment used by energy exploration and production companies.  AAR Corp. (AIR) provides supply chain and maintenance capabilities to commercial aviation and government defense markets as well as air lift services through its Expeditionary Services unit. How do their valuations stack up?

For starters, KLX’s share price (as of 2/16/2018) was $68.54., while AAR’s was $42.50. This put KLX’s market capitalization near $3.5 billion, and AAR’s at $1.5 billion.

Estimates for KLX’s fiscal 2019 earnings per share stand near $3.96, meaning its stock price reflected a forward 2019 P/E of 17.3x. We expect AAR to produce earnings of about $2.74 per share during the same period, giving it a forward 2019 P/E of 15.5x. In looking at these stocks purely on a P/E basis, AAR appears to be marginally more attractively valued.

Digging a Little Deeper
To get a more robust picture of which company is the more compelling investment, we need to consider the different levels of debt carried by the two businesses. KLX has about $900 million in net debt which, when added to its market cap, gives it an Enterprise Value around $4.4 billion. AAR has net debt of approximately $190 million, leading to an Enterprise Value of about $1.69 billion.
With respect to EBITDA, KLX is expected to generate about $369 million in fiscal 2019, while our estimates for AAR run at about $200 million. Thus, the EV/ EBITDA ratios for the two companies varied widely:
KLX: $4.4 billion EV/$369 million EBITDA = 12x 2019 Enterprise Multiple
AAR: $1.67 billion EV/$200 million EBITDA = 8.4x 2019 Enterprise Multiple
By this measure, AAR looks even cheaper than its P/E initially indicated.
Comparing KLX Inc. and AAR Corp.
  KLX Inc. (KLXI) AAR Corp. (AIR)
Share Price $68.54 $42.50
Market Cap $3.47 billion $1.50 billion
Earnings Per Share (forward 2019) $3.96 $2.74
P/E (forward 2019) 17.31x 15.51x
Net Debt $900 million $190 million
Enterprise Value $4.4 billion $1.69 billion
EBITDA (forward 2019) $369 million $200 million
Net Debt/EBITDA (forward 2018) 2.47x 1.01x
EV/EBITDA (forward 2019) 12x 8.4x

Source: Bloomberg L.P. and Heartland Advisors, Inc., as of 2/16/2018

The question that logically followed was this: Why pay a higher multiple for a potentially riskier asset? Holding AAR was an easy decision, which this examination revealed to be trading at a relative bargain.

Looking More Broadly

This approach to examining a stock is consistent with scrutiny applied by private-equity buyers or other companies seeking an acquisition. We believe using this technique helps us uncover businesses trading at a discount to their intrinsic value and ones that will be attractive to investors and acquirers alike. That’s what we care about.

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Heartland Advisors Value Investing Portfolio Manager Bradford A. Evans

Bradford A. Evans

Evans, CFA, is Senior Vice President and Portfolio Manager of the Value Plus Fund and its corresponding separately managed account strategy. He has 22 years of industry experience, 19 at Heartland.

Why Stay the Course?

Applying the key EV/EBITDA metric to the Heartland Value Plus Fund reveals an attractively priced portfolio relative to the market.

  • Consolidation multiples—the average valuations at which companies are being acquired by private-equity funds or by other companies—have been as high as 15x, depending on the industry. 
  • For the Value Plus Fund, however, the weighted average estimated 2019 Enterprise Multiple is just 8.7x, an indicator of strong cash flows as well as modest valuations*.
  • We believe our ability to identify stocks trading well below private market value is particularly advantageous at a time like this, when takeover activity has been strong.

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©2018 Heartland Advisors | 789 N. Water Street, Suite 500, Milwaukee, WI 53202 | Business Office: 414-347-7777 | Financial Professionals: 888-505-5180 | Individual Investors: 800-432-7856

*Source: FactSet Research Systems, Inc., as of 12/31/2017

Past performance does not guarantee future results.

An investor should consider the Funds’ investment objectives, risks, and charges and expenses carefully before investing or sending money. This and other important information may be found in the prospectus (pdf). To obtain a print prospectus, call 800-432-7856. Please read the prospectus carefully before investing.

The Value Plus Fund invests in small companies that are generally less liquid and more volatile than large companies. The Fund also invests in a smaller number of stocks (generally 40 to 70) than the average mutual fund. The performance of these holdings generally will increase the volatility of the Fund’s returns.

Value investments are subject to the risk that their intrinsic value may not be recognized by the broad market.

The statements and opinions expressed in the articles or appearances are those of the presenter. Any discussion of investments and investment strategies represents the presenters' views as of the date created and are subject to change without notice. The opinions expressed are for general information only and are not intended to provide specific advice or recommendations for any individual. The specific securities discussed, which are intended to illustrate the advisor’s investment style, do not represent all of the securities purchased, sold, or recommended by the advisor for client accounts, and the reader should not assume that an investment in these securities was or would be profitable in the future. Certain security valuations and forward estimates are based on Heartland Advisors’ calculations. Any forecasts may not prove to be true.

As of 12/31/2017, AAR Corp. and KLX Inc. represented 3.02% and 0.00% of the Value Plus Fund’s net assets, respectively.

Portfolio holdings are subject to change without notice. Current and future portfolio holdings are subject to risk. View full holdings as of the most recent quarter end.

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Heartland’s investing glossary provides definitions for several terms used on this page.

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