I use variety of multiples to evaluate appealing quotient of an IO for me…..EV/ebitda and cash conversion % wrt ebitda are two of the important ones…..
This is because EBITDA reflects the real earning potential of the business unless there are some hidden consistent down the line extra ordinaries whereas cash conversion % wrt to EBITDA reflects quality of the earnings of a company……will explain here with a simple theoretical example…..
Say we have a company with CMP 600, 20 cr. equity capital (2 cr. shares of fv 10 each) 500 cr. revenue as of today with 30 % EBITDA margin with 50 % EBITDA to ocf conversion and which has made front ended investments for future growth because of which its net debt on books is say 500 cr……its future potential is 20 % p.a. revenue growth over next 5 years with 1 % expansion in EBITDA margins p.a. with CAPEX requirement at 40 cr. p.a..
With this what we will have is at the end of 5 years its revenue will be ~1242 cr. with 35 % EBITDA margin and a debt free status.
Now as on date at 150 cr. EBITDA, and with 8 % depreciation rate and 50 cr. interest payment and a 34 % tax payment, we will have its EPS at 19.8…….so at CMP of 600 its P/e will be 30.3 which might look expensive but it’s EV/EBITDA will be only 11.3 which might be appealing…..
Now calculate its figures 5 years down the line, when depreciation would have got reduced to 6 % of sales, interest pay,net will be 0 because of no debt and tax rate will again be at 34 %……so with an EBITDA of 434.7 cr. it’s EPS will be 118.8……….so at 11.3 EV/EBITDA then, it’s P/e will be only 20.6 which might look appealing at that point because of company’s consistent growth track record……
It’s a theoretical example and practical examples are not that simple.
You rightly said lets keep our fingers crossed and hope for the best.
Rgds.
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