Financial Statements - The Balance

Sheet
The balance sheet provides information on what the company owns (its assets), what it
owes (its liabilities) and the value of the business to its stockholders (the shareholders'
equity) as of a specific date. It's called a balance sheet because the two sides balance
out. This makes sense: a company has to pay for all the things it has (assets) by either
borrowing money (liabilities) or getting it from shareholders (shareholders' equity).

Assets are economic resources that are expected to produce economic benefits
for their owner

Liabilities are obligations the company has to outside parties. Liabilities

represent others' rights to the company's money or services. Examples include
bank loans, debts to suppliers and debts to employees.

Shareholders' equity is the value of a business to its owners after all of its
obligations have been met. This net worth belongs to the owners. Shareholders'
equity generally reflects the amount of capital the owners have invested, plus any
profits generated that were subsequently reinvested in the company.
The balance sheet must follow the following formula:

Total Assets = Total Liabilities + Shareholders\' Equity

Each of the three segments of the balance sheet will have many accounts within it that
document the value of each segment. Accounts such as cash, inventory and property
are on the asset side of the balance sheet, while on the liability side there are accounts
such as accounts payable or long-term debt. The exact accounts on a balance sheet will
differ by company and by industry, as there is no one set template that accurately
accommodates the differences between varying types of businesses.
A balance sheet looks like this:

Source: http://www.edgar-online.com

Here are the entries you'll find on a balance sheet and what each one means. Total
Assets
Total assets on the balance sheet are composed of the following:
Current Assets - These are assets that may be converted into cash, sold or consumed
within a year or less. These usually include:

Cash - This is what the company has in cash in the bank. Cash is reported at its
market value at the reporting date in the respective currency in which the
financials are prepared. Different cash denominations are converted at the market
conversion rate.

Marketable securities (short-term investments) - These can be both equity

and/or debt securities for which a ready market exists. Furthermore, management
expects to sell these investments within one year's time. These short-term
investments are reported at their market value.

Accounts receivable - This represents the money that is owed to the company
for the goods and services it has provided to customers on credit. Every business
has customers that will not pay for the products or services the company has
provided. Management must estimate which customers are unlikely to pay and
create an account calledallowance for doubtful accounts. Variations in this
account will impact the reported sales on the income statement. Accounts

receivable reported on the balance sheet are net of their realizable value
(reduced by allowance for doubtful accounts).

Notes receivable - This account is similar in nature to accounts receivable but it

is supported by more formal agreements such as a "promissory notes" (usually a
short-term loan that carries interest). Furthermore, the maturity of notes
receivable is generally longer than accounts receivable but less than a year.
Notes receivable is reported at its net realizable value (the amount that will be
collected).

Inventory - This represents raw materials and items that are available for sale or
are in the process of being made ready for sale. These items can be valued
individually by several different means, including at cost or current market value,
and collectively by FIFO (first in, first out), LIFO (last in, first out) or average-cost
method. Inventory is valued at the lower of the cost or market price to preclude
overstating earnings and assets.

Prepaid expenses - These are payments that have been made for services that
the company expects to receive in the near future. Typical prepaid expenses
include rent, insurance premiums and taxes. These expenses are valued at their
original (or historical) cost.

Long-Term assets - These are assets that may not be converted into cash, sold or
consumed within a year or less. The heading "Long-Term Assets" is usually not
displayed on a company's consolidated balance sheet. However, all items that are not
included in current assets are considered long-term assets. These are:

Investments - These are investments that management does not expect to sell
within the year. These investments can include bonds, common stock, long-term
notes, investments in tangible fixed assets not currently used in operations (such
as land held for speculation) and investments set aside in special funds, such as
sinking funds, pension funds and plan-expansion funds. These long-term
investments are reported at their historical cost or market value on the balance
sheet.

Fixed assets - These are durable physical properties used in operations that
have a useful life longer than one year. This includes:

Machinery and equipment - This category represents the total machinery,

equipment and furniture used in the company's operations. These assets
are reported at their historical cost less accumulated depreciation.

Buildings or Plants - These are buildings that the company uses for its
operations. These assets are depreciated and are reported at historical
cost less accumulated depreciation.

Land - The land owned by the company on which the company's buildings
or plants are sitting on. Land is valued at historical cost and is not
depreciable under U.S. GAAP.

Other assets - This is a special classification for unusual items that cannot be
included in one of the other asset categories. Examples include deferred charges
(long-term prepaid expenses), non-current receivables and advances to
subsidiaries.

Intangible assets - These are assets that lack physical substance but provide
economic rights and advantages: patents, franchises, copyrights, goodwill,
trademarks and organization costs. These assets have a high degree of
uncertainty in regard to whether future benefits will be realized. They are reported
at historical cost net of accumulated depreciation.

Total Liabilities
Liabilities have the same classifications as assets: current and long term.
Current liabilities - These are debts that are due to be paid within one year or the
operating cycle, whichever is longer. Such obligations will typically involve the use of
current assets, the creation of another current liability or the providing of some service.
Usually included in this section are:

Bank indebtedness - This amount is owed to the bank in the short term, such as
a bank line of credit.

Accounts payable - This amount is owed to suppliers for products and services
that are delivered but not paid for.

Wages payable (salaries), rent, tax and utilities - This amount is payable to
employees, landlords, government and others.

Accrued liabilities (accrued expenses) - These liabilities arise because an

expense occurs in a period prior to the related cash payment. This accounting

term is usually used as an all-encompassing term that includes customer

prepayments, dividends payables and wages payables, among others.

Notes payable (short-term loans) - This is an amount that the company owes to
a creditor, and it usually carries an interest expense.

Unearned revenues (customer prepayments) - These are payments received

by customers for products and services the company has not delivered or for
which the company has not yet started to incur any cost for delivery.

Dividends payable - This occurs as a company declares a dividend but has not
yet paid it out to its owners.

Current portion of long-term debt - The currently maturing portion of the longterm debt is classified as a current liability. Theoretically, any related premium or
discount should also be reclassified as a current liability.

Current portion of capital-lease obligation - This is the portion of a long-term

capital lease that is due within the next year.

4. Long-term Liabilities - These are obligations that are reasonably expected to be

liquidated at some date beyond one year or one operating cycle. Long-term obligations
are reported as the present value of all future cash payments. Usually included are:

Notes payables - This is an amount the company owes to a creditor, which

usually carries an interest expense.

Long-term debt (bonds payable) - This is long-term debt net of current portion.

Deferred income tax liability - GAAP allows management to use different

accounting principles and/or methods for reporting purposes than it uses for
corporate tax fillings to the IRS. Deferred tax liabilities are taxes due in the future
(future cash outflow for taxes payable) on income that has already been
recognized for the books. In effect, although the company has already recognized
the income on its books, the IRS lets it pay the taxes later due to the timing
difference. If a company's tax expense is greater than its tax payable, then the
company has created a future tax liability (the inverse would be accounted for as
a deferred tax asset).

Pension fund liability - This is a company's obligation to pay its past and current
employees' post-retirement benefits; they are expected to materialize when the
employees take their retirement for structures like a defined-benefit plan. This
amount is valued by actuaries and represents the estimated present value of

future pension expense, compared to the current value of the pension fund. The
pension fund liability represents the additional amount the company will have to
contribute to the current pension fund to meet future obligations.

Long-term capital-lease obligation - This is a written agreement under which a

property owner allows a tenant to use and rent the property for a specified period
of time. Long-term capital-lease obligations are net of current portion.

Financial Statements - The Income

Statement
The income statement measures a company's financial performance over a
specific accounting period. Financial performance is assessed by giving a summary of
how the business incurs its revenues and expenses through both operating and nonoperating activities. It also shows the net profit or loss incurred over a specific
accounting period, typically over a fiscal quarter or year. The income statement is also
known as the "profit and loss statement" or "statement of revenue and expense."
The income statement is divided into two parts: the operating items section and the nonoperating items section.
The operating items section discloses information about revenues and expenses that are
a direct result of the regular business operations. For example, if a business creates
sports equipment, then the operating items section would talk about the revenues and
expenses involved with the production of sports equipment.
The non-operating items section discloses revenue and expense information about
activities that are not tied directly to a company's regular operations. For example, if the
sport equipment company sold a factory and some old plant equipment, then this
information would be in the non-operating items section. Income statements can be
presented in one of two ways: multi-step and single-step. Both single and multi-step
formats conform to GAAP standards. Both yield the same net income figure; the main
difference is how they are formatted, not how figures are calculated. The two formats are
illustrated below in two simplistic examples:

Multi-Step
Single-Step Format
Format
Net Sales
Net Sales
Cost of Sales
Materials and Production
Gross Income*
Marketing and Administrative
Selling, General
Research and Development
and Administrative
Expenses(R&D)
Expenses (SG&A)
Operating
Other Income & Expenses
Income*
Other Income &
Pretax Income
Expenses
Pretax Income*
Taxes

Taxes
Net Income
Net Income (after
-tax)*

Sample Income Statement

Now let's take a look at a sample income statement for company XYZ for Fiscal Year
(FY) ending 2008 and 2009. Expenses are in parentheses.

Income Statement For Company XYZ FY 2008 and

2009

(Figures USD)
Net Sales
Cost of Sales
Gross Income
Operating Expenses (SG&A)
Operating Income
Other Income (Expense)
Extraordinary Gain (Loss)
Interest Expense
Net Profit Before Taxes (Pretax
Income)
Taxes
Net Income

2008
2009
1,500,000 2,000,000
(350,000) (375,000)
1,150,000 1,625,000
(235,000) (260,000)
915,000 1,365,000
40,000 60,000
(15,000)
(50,000) (50,000)
905,000 1,360,000
(300,000) (475,000)
605,000 885,000

Here are some of the different entries that may be found on the income statement and
what each one means.

Sales - These are defined as total sales (revenues) during the accounting period.
Remember these sales are net of returns, allowances and discounts.

Cost of Goods Sold (COGS) - These are all the direct costs that are related to
the product or rendered service sold and recorded during the accounting period.
(Reminder: matching principle.)

Operating expenses - These include all other expenses that are not included in
COGS but are related to the operation of the business during the specified
accounting period. This account is most commonly referred to as "SG&A" (sales
general and administrative) and includes expenses such as selling, marketing,
administrative salaries, sales salaries, maintenance, administrative office
expenses (rent, computers, accounting fees, legal fees), research and
development (R&D), depreciation and amortization, etc.

Other revenues & expenses - These are all non-operating expenses such as
interest earned on cash or interest paid on loans.

Income taxes - This account is a provision for income taxes for reporting
purposes.

The Components of Net Income:

Operating income from continuing operations - This comprises all revenues

net of returns, allowances and discounts, less the cost and expenses related to
the generation of these revenues. The costs deducted from revenues are typically
the COGS and SG&A expenses.

Recurring income before interest and taxes from continuing operations - In

addition to operating income from continuing operations, this component includes
all other income, such as investment income from unconsolidated subsidiaries
and/or other investments and gains (or losses) from the sale of assets. To be
included in this category, these items must be recurring in nature. This
component is generally considered to be the best predictor of future earnings.
However, non-cash expenses such as depreciation and amortization are not
assumed to be good indicators of future capital expenditures. Since this
component does not take into account the capital structure of the company (use
of debt), it is also used to value similar companies.

Recurring (pre-tax) income from continuing operations - This component

takes the company's financial structure into consideration as it deducts interest
expenses.

Pre-tax earnings from continuing operations - Included in this category are

items that are either unusual or infrequent in nature but cannot be both. Examples
are an employee-separation cost, plant shutdown, impairments, write-offs, writedowns, integration expenses, etc.

Net income from continuing operations - This component takes into account
the impact of taxes from continuing operations.

Non-Recurring Items
Discontinued operations, extraordinary items and accounting changes are all reported as
separate items in the income statement. They are all reported net of taxes and below the
tax line, and are not included in income from continuing operations. In some cases,
earlier income statements and balance sheets have to be adjusted to reflect changes.

Income (or expense) from discontinued operations - This component is

related to income (or expense) generated due to the shutdown of one or more
divisions or operations (plants). These events need to be isolated so they do not
inflate or deflate the company's future earning potential. This type of nonrecurring
occurrence also has a nonrecurring tax implication and, as a result of the tax
implication, should not be included in the income tax expense used to
calculate net income from continuing operations. That is why this income (or
expense) is always reported net of taxes. The same is true for extraordinary items
and cumulative effect of accounting changes (see below).

Extraordinary items - This component relates to items that are both unusual and
infrequent in nature. That means it is a one-time gain or loss that is not expected
to occur in the future. An example is environmental remediation.

Cumulative effect of accounting changes - This item is generally related to

changes in accounting policies or estimations. In most cases, these are non
cash-related expenses but could have an effect on taxes.

Unusual or Infrequent Items

Included in this category are items that are either unusual or infrequent in nature
but they cannot be both.

Examples of unusual or infrequent items:

Gains (or losses) as a result of the disposition of a company's business segment

including:

Plant shutdown costs

Lease-breaking fees

Employee-separation costs

Gains (or losses) as a result of the disposition of a company's assets or

investments (including investments in subsidiary segments) including:

Plant shut-down costs

Lease-breaking fees

Gains (or losses) as a result of a lawsuit

Losses of operations due to an earthquake

Impairments, write-offs, write-downs and restructuring costs

Integration expenses related to the acquisition of a business

Extraordinary Items
Events that are both unusual and infrequent in nature are qualified as
extraordinary expenses.

Example of extraordinary items:

Losses from expropriation of assets

Gain (or losses) from early retirement of debt

Discontinued Operations
Sometimes management decides to dispose of certain business operations but either
has not yet done so or did it in the current year after it had generated income or losses.
To be accounted for as a discontinued operation, the business must be physically and
operationally distinct from the rest of the firm. Keep in mind these basic definitions:

Measurement date This is the date when the company develops a formal plan
for disposing.

Phase-out period This is the time between the measurement date and the
actual disposal date.

The income or loss from discontinued operations is reported separately, and past income
statements must be restated, separating the income or loss from discontinued
operations.
On the measurement date, the company will accrue any estimated loss during the

phase-out period and estimated loss on the sale of the disposal. Any expected gain on
the disposal cannot be reported until after the sale is completed (the same rule applies
to the sale of a portion of a business segment).
Accounting Changes
Accounting changes occur for two reasons:
1. As a result of a change in an accounting principle.
2. As a result of a change in an accounting estimate.
The most common form of a change in accounting principle is the switch from
the LIFO inventory accounting method to another method such FIFO or average cost
basis.
The most common form of a change in accounting estimates is a change in depreciation
method for new assets or change in depreciable lives/salvage values, which is
considered a change in accounting estimates and not a change in accounting principle.
Note that past income does not need to be restated from the LIFO inventory accounting
method to another method such FIFO or average cost basis.
In general, prior years' financial statements do not need to be restated unless it is a
change in:

Inventory accounting methods (LIFO to FIFO)

Change to or from full-cost method (This is used in oil and gas exploration. The
successful-efforts method capitalizes only the costs associated with successful
activities while the full-cost method capitalizes all the costs associated with all
activities.)

Change from or to percentage-of-completion method (see revenue-recognition

methods)

All changes just prior to a company's IPO

Prior Period Adjustments

These adjustments are related to accounting errors. These errors are
typically not reported in the income statement but are reported in retained earnings
(found in changes in retained earnings). These errors are disclosed as footnotes
explaining the nature of the error and its effect on net income.

Financial Statements - Cash Flow

The statement of cash flow reports the impact of a firm's operating, investing
and financial activities on cash flows over an accounting period.
The cash flow statement shows the following:
How the company obtains and spends cash
Why there may be differences between net income and cash flows
If the company generates enough cash from operation to sustain the
business
If the company generates enough cash to pay off existing debts as they
mature
If the company has enough cash to take advantage of new investment
opportunities
Segregation of Cash Flows
The statement of cash flows is segregated into three sections:
Operating activities
Investing activities
Financing activities
1. Cash Flow from Operating Activities (CFO)
CFO is cash flow that arises from normal operations such as revenues and
cash operating expenses net of taxes.
This includes:
Cash inflow (+)
1. Revenue from sale of goods and services

2. Interest (from debt instruments of other entities)

3. Dividends (from equities of other entities)
Cash outflow (-)
1. Payments to suppliers
2. Payments to employees
3. Payments to government
4. Payments to lenders
5. Payments for other expenses
2. Cash Flow from Investing Activities (CFI)
CFI is cash flow that arises from investment activities such as the acquisition
or disposition of current and fixed assets.
This includes:
Cash inflow (+)
1. Sale of property, plant and equipment
2. Sale of debt or equity securities (other entities)
3. Collection of principal on loans to other entities
Cash outflow (-)
1. Purchase of property, plant and equipment
2. Purchase of debt or equity securities (other entities)
3. Lending to other entities

3. Cash flow from financing activities (CFF)

CFF is cash flow that arises from raising (or decreasing) cash through the
issuance (or retraction) of additional shares, or through short-term or longterm debt for the company's operations. This includes:
Cash inflow (+)
1. Sale of equity securities
2. Issuance of debt securities
Cash outflow (-)
1. Dividends to shareholders
2. Redemption of long-term debt
3. Redemption of capital stock
A cash flow statement looks like this:

Reporting Non-Cash Investing and Financing Transactions

Information for the preparation of the statement of cash flow is derived from
three sources:
1. Comparative balance sheets
2. Current income statements
3. Selected transaction data (footnotes)
Some investing and financing activities do not flow through the statement of
cash flow because they do not require the use of cash.
Examples Include:

 Conversion of debt to equity

Conversion of preferred equity to common equity
Acquisition of assets through capital leases
Acquisition of long-term assets by issuing notes payable
Acquisition of non-cash assets (patents, licenses) in exchange for
shares or debt securities

Though these items are typically not included in the statement of cash flow,
they can be found as footnotes to the financial statements.

Find out why EV/EBITDA is better than price to

earnings ratio
Sameer Bhardwaj, ET Bureau Jan 20, 2014, 08.00AM IST

Tags:

Shares|
Insurability|
Embedded Value|
depreciation

(The ratio has two components:)

Financial analysts employ several valuation ratios for analysing and identifying over- and undervalued
stocks. Most research reports concentrate on the application of such valuation ratios and say very
little about the rudiments.
It is important for small investors to understand the basics of such ratios as these can help them
analyse the stocks more effectively.

In the first part of the series on understanding financial ratios, we look at the EV/EBITDA ratio, which
is preferred by some analysts over the price to earnings or PE ratio.
HOW TO CALCULATE THE RATIO
This ratio has two components: EV and EBITDA. EV, or enterprise value, is calculated by adding the
market value of equity and debt, and subtracting the cash holding as shown in the firm's book of
accounts. It gives the cost of acquiring business, as the buyer needs to pay the market value of equity
or market capitalisation while purchasing the company. However, the cash with the firm acts as a
cushion for the buyer and needs to be deducted.
The value of debt must also be included while estimating the acquisition cost since the interest cost
on debt can affect the firm's future cash flow and the principal is repayable on maturity.

The other part of the metric is the EBITDA, which is also known as the operating profit. EBITDA is the
earning before interest cost, tax, depreciation and amortisation, and appears in the firm's income
statement. The other way of arriving at EBITDA is by adding depreciation, interest cost and tax to the
net earning.
Comparing the firm's performance based on net earning leads to a bias due to differences in
accounting policies and capital structures. This is because some firms may charge depreciation on an
accelerated basis, which leads to high depreciation costs in the initial years.
In addition, some firms have a high debt in their capital structure leading to high interest costs. Such
depreciation and interest costs ultimately depress the net earnings. EBITDA discards such difficulties
due to varying depreciation policies and debt-equity mix. This measure of earning is also sometimes
used as a proxy for cash flow as it adds the non-cash expenditure (depreciation).
HOW IT DIFFERS FROM PE RATIO
The PE ratio measures the money that investors are willing to pay for every rupee a company earns.
It is a metric used for valuing the firm's equity as it takes into account the residual earning available to
equity shareholders.
Though widely used, PE ratio has its limitations as it cannot be used for valuing lossmaking
companies and fails to overcome the distortions caused by different accounting policies and capital
structures.
The EV/EBITDA ratio is better as it values the worth of the entire company. PE ratio gives the equity
multiple, whereas EV/EBITDA gives the firm multiple. The latter is based on the notion of most
successful investors, who propose that equity investing is not just buying/selling shares, but
buying/selling the business.
WHAT THE RATIO MEANS
The division of EV by EBITDA gives a good measure of value. It estimates the number of years in
which the business will repay its acquisition cost to the buyer through its earnings. For example, if one
is interested in buying a firm at an EV of Rs 1,000 crore and its annual earning (EBITDA) is Rs 200
crore, the firm will repay its entire acquisition cost to the buyer in cash in just five years.
Generally, the lower the ratio, the better it is. The ratio helps determine the true earning potential of
the business. It is ideal for valuing telecommunication and cement & steel companies as these carry a
high debt in their balance sheets and have high gestation periods.
The ratio proves a great tool for valuing companies that are making losses at the net earning level, but
are profitable at the EBITDA level. However, the ratio is harder to calculate as it requires several
adjustments in the net income.
Also, EV value is not readily available and has to be derived from the firm's financial statements.
Estimating the true market value of debt is also not easy as it is influenced by changes in interest
rates.

This post was prompted by a minor change in the standard Bloomberg

company description which I noticed over the last view months. If one
uses the function DES Bloomberg provides on page 3 some standard
ratios which are quite helpful in order to get a first view on a company.
Within the screen there are 6 boxes, the upper left box showing currently
the following ratios (example: National Oilwell Varco, NOV US):
Issue Data
~ Last Px USD/80.91
~ P/E 14.4
~ Dvd Ind Yld 1.3%
* P/B 1.60
~ P/S 1.5
~ Curr EV/T12M EBIT 8.6
~ Mkt Cap 34,637.6M
~ Curr EV 35,743.6M
Interestingly, a few weeks ago (??), one would get EV/EBITDA instead of
EV/EBIT. I am not sure why they changed it, but it is a good starter in
order to think about the differences between P/E, EV/EBITDA and EV/EBIT
The P/E ratio
The P/E ratio is clearly the most famous valuation ratio. A low P/E strategy
still seems to work. In my opinion, the P/E ratio clearly has two major
fundamental drawbacks as a strong criteria for me as a stock picker:
it does not reflect net debt or net cash
under IFRS, many items (Pensions, currency changes) are booked
directly into equity. This is the reason why I prefer P/Comprehensive
income
EV/EBITDA Ratio
The classic EV/EBITDA ratio is much better in capturing debt and net
cash than the P/E. As I have explainedin an earlier post, one should be
careful with EV in certain cases (leases, pensions), but overall, EV is much
better to compare highly leveraged companies with conservative
companies
EBITDA, as the name says, is
Earnings before Interest, Taxes, Depriciation and Amortization. Some

people have called it Earnings before everything else but in theory,

EBITDA should be a proxy for operating cashflow.
As I have written before, this metric has been used a lot by Private equity
buyers in order to assess, how much debt could be pushed into a
company unitl it chokes.
In the latest edition of OShaugnesseys What works on Wall Street,
EV/EBITDA is also one of the strongest single factors, much better than
P/B and P/E.
The problem with EBITDA is that although it might approximate Operating
Cashflow, it does not equal free cashflow. The D in EBITDA means
depreciation. If you leave out depreciation, the effect will be that capitalintensive businesses which need a lot of capex (and depreciation) look
suddenly quite good, although this cashflow never reaches the equity
holder, because it is necessary to maintain the productive capital.
We can see this easily if we look at the DAX companies, sorted by
EV/EBITDA:

EV/EBITDA T12
Deutsche Lufthansa AG

3.26

RWE AG

3.51

K+S AG

4.33

Continental AG

4.78

E.ON SE

4.80

Deutsche Telekom AG

5.85

ThyssenKrupp AG

6.27

HeidelbergCement AG

6.82

Volkswagen AG

6.93

LANXESS AG

7.25

Bayerische Motoren Werke AG

7.26

Deutsche Post AG

8.19

Infineon Technologies AG

8.19

Fresenius SE & Co KGaA

8.74

BASF SE

8.82

Bayer AG

8.97

Linde AG

9.10

Merck KGaA

9.12

Fresenius Medical Care AG & Co KGaA

10.33

Siemens AG

11.05

Henkel AG & Co KGaA

11.46

Adidas AG

11.85

Daimler AG

11.86

Deutsche Boerse AG

13.64

SAP AG

13.93

Beiersdorf AG

15.59

The cheap stocks are those companies, which are REALLY capitalintensive. Clearly, RWE and EON need to continuously reinvest into their
huge power stations or they will not be able to produce any electricity
soon. On the other hand, Deutsch Brse is basically a market making
software with some computers and a government license. Very few assets,
small depreciation.
So the difference between low EV/EBITDA and HIGH EV/EBITDA is not
necessarily cheapness but different levels of capital intensity
EV/EBIT
This is why many professionals prefer EV/EBIT to EV/EBITDA. EBIT
already deduces depreciation and should therefore be a better proxy
for Free cashflow than EBITDA.
Lets look at the Dax companies sorted by EV/EBIT:
EV/T12M EBIT

EV/EBITDA T12M

SDF GY Equity

5.7

4.3

CON GY Equity

7.5

4.8

EOAN GY Equity

7.5

4.8

RWE GY Equity

7.9

3.5

FRE GY Equity

11.2

8.7

HEI GY Equity

11.2

6.8

TKA GY Equity

11.3

6.3

DPW GY Equity

12.3

8.2

BAYN GY Equity

12.7

9.0

BAS GY Equity

13.0

8.8

FME GY Equity

13.4

10.3

HEN3 GY Equity

13.6

11.5

LXS GY Equity

13.6

7.3

BMW GY Equity

13.9

7.3

DTE GY Equity

14.3

5.8

DB1 GY Equity

15.8

13.6

VOW3 GY Equity

16.0

6.9

SIE GY Equity

16.2

11.0

LHA GY Equity

16.2

3.3

MRK GY Equity

16.6

9.1

LIN GY Equity

16.7

9.1

SAP GY Equity

17.0

13.9

BEI GY Equity

18.3

15.6

ADS GY Equity

18.6

11.9

DAI GY Equity

19.2

11.9

IFX GY Equity

22.5

8.2

avg

13.9

8.5

I have added also EV/EBITDA and P/E in this table. It is interesting

that P/Es look rather random when we sort by EV/EBIT. Especially
Lufthansa looks now really expensive as well as Daimler and Infineon. On
the other hand, a relatively expensive looking stock like Fresenius now

looks rather cheap. A company like Beiersdorf looks expensive in any

metric and th utilities look still cheap but not Deutsch TeleKom.
For the utility stocks for instance I think EV is too low, because one needs
to add the liabilities for decommissioning the Nuclear plants to EV.
A quick word on Free Cash flow and P/Free cashflow ratio
As I have written earlier, one really has to be carefull with reported free
cash flows. Cashflow statement are not really audited and it is quite easy
to massage the categories. Free cash flow is clearly an important
number to look at in a second step, but as a standard indicator it has very
limited use in my opinion.
Some additional pitfalls
Using EV/EBITDA and EV/EBIT smoetimes can also be tricky. Among others
are operating leases, pensions, certain prepayments etc. which can
change EV dramatically. But there can also be issues on the EBIT/EBITDA
side:
For instance, those are the stats for Statoil ASA, the Norwegian Oil
company:
P/E 11.8
EV/EBITDA 2.2
EV/EBIT 3.3
From an EVEBit perspective, this clearly looks like a no brainer: we only
pay 3 times EBIT for a rock solid oil and gas company. Well, but we might
have forgotten one important thing: Between EBIT and Free cash flow we
have still two other items: Interest and Taxes.
As Statoil doesnt pay much interest (only 2% of EBIT) the issues is clearly
taxes. Statoil is subject to special taxes, which on average amount to
75% of EBIT. There might be some leeway to shelter certain tax payments,
but in a country like Norway the companies will have to pay most of those
taxes in cash.
Interest and Taxes are especially important if one compares companies
across different countries. All other things equal, companies in high tax
rate countries with high taxes will trade at lower EV/EBIT and EV/EBITDA
multiples than in low tax low-interest rate countries. So fo instacne the

Swiss MArket Index trades at 16.7 x EBIT and 12.2 EBITDA significantly
higher than the German index. At least part of that is due to the much
lower tax rate in Switzerland and even lower interest rates.
So a comparison of peer companies across countries with very different
tax rates ind interest rates should not solely be based on EV/EBIT or
EV/EBITDA.
Other issues with EV/EBIT and EV/EBITDA financial companies
and financing business
EV measures usually dont work well with financial companies and also
companies which have a lot of financing business on their books.
Originally, EV is meant to capture real leverage, i.e. debt issued to pay
for machinery, inventory etc. Debt issued to fund for instance client
purchases is referred to as operating leverage. It is a little bit a grey
area. Clearly, one should prefer a company which sells only stuff against
cash than financing it for several years. The financial crisis in 2008 has
shown that such operating leverage quickly became strategic if the
roll over doesnt work. On the other hand, in normal times operating
leverage could be potentially adjusted against EV as you have extra
assets.
If one tries to compare financial companies vs. industrial companies
though, P/E is clearly more useful, as financial companies per definition
have much higher EVs than non-financial companies.
Price /Comprehensive income
This is a ratio which I use especially for financial companies.
Comprehensive income inlcudes all kind of value changes which are
booked directly against equity, such as changes in the value of pension
libailities, value changes of financial assets including hedges, currency
translations etc. Especially for financial companies, comprehensive
income is a pretty good leading indicator although it is rarely used in
my experience.
Summary:
In general, I would recommend to look at all Popular ratios in parallel,
because it gives a better multi dimensional view on a company. For

Normal company, in my opinion, EV/EBIT is the most significant ratio,

followed by P/Comprehensive Income.
P/Es and Ev/EBITDA are clearly also helpful. The most interesting cases are
those, where the different ratios are completely different. This is often an
indicator for somthing special going on and potentially a stock to
investigate further.
In any case, although I like EV/EBIT, one should always look down in the
P/L to the real bottom line (comprehenive income) as good CFOs are
quite creative in moving expenses down the chain where many people
dont bother to look any more.
Finally as a special service, an overview over the different ratios and when
to use them: