We haven't shown these charts for quite a while, so here they are today.
As I have said before, when one company acquires another company, they don't look at the target company on a Price (P) to Earnings (E) (PE) basis. Instead, the metric looked at for an entire business valuation is the Enterprise Value (EV) to Ebitda (EV/Ebitda).
EV includes the price the target company's stock is trading at (the market capitalization), plus all the debt and less the cash (if any) on the balance sheet. The difference between looking at EV vs just the Price of a company's stock is obviously that EV includes the debt (which is part of the capitalization of the company) but also deducts the cash (because cash on the balance sheet does not get a "multiple" put on it as cash doesn't help drive cash flow). So, to conclude the difference in the numerator of the formula, EV is a more all-encompassing metric than Price (P). Can you imagine buying a business and just looking at the Price you are paying for their stock, even though you have to buy the Debt too!?! Might make sense to look at how much debt that company has.
On the denominator, Earnings (E) in the PE multiple is the "bottom-line" on the Income Statement. It includes all kinds of things like non-cash expenses like depreciation and amortization etc. It can also be highly manipulated. Ebitda on the other hand, is seen more as a pure measurement of the company's actual cash flow. It stands for Earnings before Interest Expense, Taxes and Depreciation/Amortization. Ebitda can also be manipulated so it pays to reverse-engineer the company's own calculations if need be.
Armed with the "real" valuation metric for looking at the market, let's check two charts and see where we are at.
The first chart is the EV/Ebitda of the S&P 500 going back 30 years (as far back as Bloomberg calculates). You will note the Current EV/Ebitda (white arrow) is at 13.2x. That is to say, the market is currently pricing a valuation today of 13.2x the last twelve months of Ebitda. Looks a bit stout doesn't it, given we were only higher than this in 1999 before the Tech Bubble burst? The red arrow shows the forward multiple of 10.5x or the Forward EV/Ebitda for the next twelve months but the graph doesn't help us much on this metric historically as it doesn't graph the multiple on a forward basis.
And, just for fun, let's look at the way retail investors might look at the Ebitda metric: on a Price to Ebitda basis (like PE but using Ebitda instead of Earnings). (Note: this metric excludes the debt of the S&P 500 companies). As you can see, this metric has never been higher than it is today. Remember, this excludes the debt on the balance sheet of those S&P 500 companies...really just the price of the stock.
What you should notice between the two charts is that, we have isolated the debt and excluded it from the second chart. So the EV is not at an all-time high multiple in the first chart but the P is in the second chart. Conclusion: it is the P (the stock price) that is driving overvaluation rather than the Debt (which is absent in the second chart).
A word about "multiples", whether you look at the PE or the EV/Ebitda: 1) higher growth companies typically trade at higher multiples, because of their growth prospects, and buyers (acquirers, both retail investors and strategic buyers) are willing to pay a higher multiple for that growth and 2) when multiples are stretched/high, one of two things has to happen: a) the Ebitda (earnings/cash flows) has to actually come to fruition and if the Ebitda doesn't come to fruition like the market hopes/thinks, then b) the EV or P will need to sell off to bring the multiple back in-line with a more average multiple (mean reversion).
The take-away is multiple expansion can only go on for so long without Earnings/Ebitda coming to fruition to justify the multiple. As always, time will tell but till then, we will be more cautious on the generic market.
Source: Bloomberg, January 16, 2017