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Even Quality Will Be Sold When Things Get Messy

Phoenix Capital Research's picture




 

 

On that note, I want to point out that some of the best businesses in the world are beginning to approach valuations that are attractive (see Figure 1 below).

 

In terms of valuing a company, there are two key metrics I like. One is Enterprise Value (EV) divided by Earnings Before Taxes Interest Depreciation and Appreciation (EBITDA) or EV/ EBITDA.

 

I prefer this metric to the more traditional Price to Earnings (P/E) valuation metric because both Price (Market Cap) and Earnings are not very accurate measurements of a company’s health.

 

 

Regarding price, consider the following… a company that has a market cap of $10 billion, earnings $2 billion, has $2 billion in cash and has $9 billion in debt will look cheap with a P/E of 5… even though its debt load could bankrupt it.

 

Enterprise Value clears this issue up by including a company’s debt and cash on hand in the valuation process: EV is a company’s market cap, plus its debt, minus its cash. As such it is a much closer approximation of a company’s health than market cap.

 

Regarding earnings, as I noted in previous articles there are dozens and I literally mean dozens of ways to craft earnings to be better than reality.

 

For that reason I prefer Earnings Before Taxes Interest Depreciation and Appreciation (EBITDA) as a metric for a company’s earning potential.

 

I realize this term sounds confusing, but EBITDA is essentially the money a company generates before it pays taxes or manipulates the value of the assets on its balance sheet. As such it’s a much cleaner representation of the cash a company generates.

 

Thus, EV/ EBITDA is a much better valuation metric than P/E. For that reason I’ve priced the businesses in Figure 1 by EV/ EBITDA.

 

Another term you need to know about is earnings yield. For those of you who are unfamiliar with earnings yield, this is essentially a ratio made by dividing a company’s Earnings Per Share by its Price Per Share.

 

I like to use this ratio relative to the yield on the ten-year Treasury (which is considered risk free) to asset the benefit of owning a stock. Given the increased risk of owning a stock, the earnings yield should be dramatically higher than the yield on the Ten Year Treasury.

 

However, the cash a company generates does not necessarily equal the cash it pays its owners. So I also like to consider a businesses’ dividend yield relative to the yield on the Ten Year Treasury as well.

 

These three metrics (EV/ EBITDA, Earnings Yield, Dividend Yield) can be used to give a decent “back of the envelope” assessment of the value of a stock.

 

As you can see in Figure 1 above, some of the best businesses in the world are beginning to trade at attractive valuations from an EV/EBITDA and Earnings Yield perspective.

 

However, the dividend yield is generally less attractive for most of these companies than the yield on the Ten Year Treasury. And given that stocks are far more volatile, I believe there is simply too much risk here relative to the cash reward for owning them at this time.

 

I bring all of this up, because I want to make you aware that the bargain basement sale I predicted last issue is only just beginning. And while it is tempting to start backing up the truck to invest, we need to consider the old adage that the fact a stock is cheap doesn’t mean it cannot get cheaper.

 

Between the low dividends and the risk to the global economy I’ve outlined in last issue, these valuations, while attractive, are not nearly as attractive as I’d like.

 

When you can buy a business like Apple at a dividend yield of 4+% at a time when the 10 Year Treasury is yielding 2.0% or less, THEN it’s time to go shopping based on the potential risk reward.

 

This time is coming. But it’s not here yet. The macro picture for the world is dangerous. And high quality companies will not be spared the carnage if a market onslaught begins (which is looking increasingly likely).

 

For a FREE Special Report outlining how to protect your portfolio from the Fed’s policies, swing by: http://phoenixcapitalmarketing.com/special-reports.html

 

Best

Phoenix Capital Research

 

 

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Tue, 10/22/2013 - 11:12 | 4079490 Widowmaker
Widowmaker's picture

Inflated mark to fantasy valuation does not imply "quality."

Pick a sector, fraud fiat is dying.

 

Tue, 10/22/2013 - 11:12 | 4079489 Its_the_economy...
Its_the_economy_stupid's picture

If one does not look at Growth Rate and factor out cost-cutting measures that can influence the same, one might very well buy equities "cheaply" that are on the way down (which is why they are cheap to begin with). Value  company as you wish, but withourt a review of growth or lack thereof, you might as well throw darts. In fact, throwing darts is less work and more fun on the way to Snap card registration.

Tue, 10/22/2013 - 10:37 | 4079363 TradingTroll
TradingTroll's picture

Accounting. Nope, the A in EBITDA stands for Accounting. Good ole accounting. Earnings are reported before Accounting. I'm sure thats right. ;)

Tue, 10/22/2013 - 09:49 | 4079216 Dweeb
Dweeb's picture

I am shocked to hear this guy write about EBITD and Appreciation.   It's Amortization ... not Appreciation and there's a totally different meaning.  This displays an appalling lack of Financial literacy or sloppy writing/proof-reading.   It's telling that a marketing-driven company like Phoenix would allow this kind of goof.

 

 

Tue, 10/22/2013 - 11:32 | 4079574 TGR
TGR's picture

I did a double-take on that too, assuming it was a simple typo until he kept repeating it.

//
Tue, 10/22/2013 - 11:15 | 4079506 kaiserhoff
kaiserhoff's picture

Amen.

There are no Blue chip stocks in the current environment.

Kraft and Exxon make some sense, but retailing and Crapple?  WTF

Silver, Brass, and Lead, (and canned goods and oats), in the order of your choice and needs.

Tue, 10/22/2013 - 09:40 | 4079184 Zero Point
Zero Point's picture

10 year is risk free, and blah blah, blahde blah...

Tue, 10/22/2013 - 08:08 | 4078813 Randoom Thought
Randoom Thought's picture

If it goes like the last "crisis" then even metals and other commodities will crater when the stock market craters. When collateral and thereby leverage dries up, money has to be taken out.

Tue, 10/22/2013 - 10:17 | 4079300 covert
covert's picture

nothing ever outperforms platinum and education.

nuff said.

http://covert.nl.ae/forum/viewtopic.php?f=26&t=12

Tue, 10/22/2013 - 10:15 | 4079287 Its_the_economy...
Its_the_economy_stupid's picture

Its "sell what you can" when TSHTF. The best co.'s will sell to meet margin and withdrawals.

Tue, 10/22/2013 - 09:09 | 4079075 shovelhead
shovelhead's picture

Identify solid co.s with bundles of cash and wait for the 50% off sale.

 

Tue, 10/22/2013 - 04:33 | 4078636 strannick
strannick's picture

This from the guys who said there would be no QE4

Tue, 10/22/2013 - 07:45 | 4078779 Laughing Stock
Laughing Stock's picture

Yeah, no kidding!

This Alpha-Hotel (Miami Vice reference, look it up) has been yammering about the end of the world for years...now, after massive gains and the market at ATFH he's getting his buy list together?

You've gotta be kiddin' me

Dump this jerk's posts

Please...for the good of the board!

Tue, 10/22/2013 - 09:47 | 4079208 Popo
Popo's picture

This dipshit brings down the quality level of ZH.

Do NOT follow this link or you will be banned from the site!