An article in Forbes features an interview with Michael Mauboussin, Director of Research at BlueMountain Capital Management. The interview focused on Mauboussin’s recent paper discussing “the merits and pitfalls of the usage of EV/EBITDA in valuation work.”
Here are some highlights:
Multiples, says Mauboussin, are used as a form of “shorthand” to avoid the use of a discounted cash flow model in valuing stocks (the results of which can vary significantly based on the inputs used). The downside of multiples, however, is that they present “blind spots.” Price-earnings and EBITDA, for example, have a number of limitations but the main one is that they fail to account for capital intensity—be it working capital, capital expenditures, or acquisitions.”
Mauboussin’s advice for value investors “balancing between flexibility and discipline in the investment process” is to “be good at updating your prior view as new information reveals itself.”
The most common execution-related mistakes that investment managers make, says Mauboussin, are:
- Failure to distinguish between fundamentals and expectations. “You don’t generate excess returns by picking winners,” Mauboussin argues, but rather by “figuring out which horse has odds that mis specify the horse’s chances of winning.”
- “The lack of congruence between actual process and espoused goals.” According to Mauboussin, investment managers should periodically step back and ask whether what they are doing is likely to generate excess returns over time and, if so, whether their process fully serves that goal.”
The use of EBITDA: “Companies generally try to make their results look good,” says Mauboussin. The antidote, he argues, it to focus on free cash flow. “At the end of the day, free cash flow is the money available for distribution to the claimholders. And that is the lifeblood of value.”
Mauboussin offers insights regarding the factors that lead to divergence between EV/EBITDA and P/E multiples, as well as when analysts should rely on one versus the other.
On the limitations of EV/EBITDA: Mauboussin asserts that EBITDA understates the capital intensity of a business and overstates the amount of cash a company can distribute. He adds that these multiples “in general do not explicitly reflect business risk” including operating leverage (the percentage change in operating profit as a function of the percentage change in sales).