When considering valuation-conscious investing, often the first metric that comes to mind is price/earnings. This fundamental measure of value identifies stocks whose share prices are moderate relative to their profitability. However, it takes more than just one factor to get through Heartland's investment process. Another less-understood valuation measure, the “Enterprise Multiple,” can help identify true discounted companies.
The Enterprise Multiple is often expressed as a ratio of Enterprise Value to earnings from operations, or EBITDA (earnings before interest, taxes, depreciation and amortization are deducted). EV suggests the approximate price to acquire the company as a whole because EV takes into account debt, other liabilities and cash reserves. Examining the ratio of EV/EBITDA can help clarify whether a company genuinely represents an attractive value.
For example, consider these two health care companies, facing essentially the same challenges and looking toward similar opportunities. Omnicare Inc. (OCR) and Pharmerica Corp. (PMC) both operate institutional pharmacies that primarily serve residents in skilled nursing facilities, have capable management teams, are positioned to benefit from the demographic trend of an aging population, and could gain further market share as their industry continues to consolidate.
Looking at these stocks purely on a P/E basis, the two appear to be about evenly—and reasonably—valued. Based on share prices as of mid-November and 2014 earnings estimates, Omnicare's P/E ratio is about 14.4x and Pharmerica's is 13.7x.
What this perspective doesn't consider, however, is the different levels of debt carried by each. Omnicare carries substantially more net debt relative to the company's earnings. Therefore, the two companies' EV/EBITDA ratios are significantly different: 10.2x for Omnicare vs. 6.5x for Pharmerica.
By this measure, Pharmerica is revealed to be significantly cheaper than Omnicare. Furthermore, we feel Omnicare's higher net debt relative to its earnings raises the risk associated with the stock.
The question that logically follows is this: Why pay a higher multiple for a riskier asset? So it was an easy decision for us to take a profit and sell Omnicare, which the Enterprise Multiple exposed as quite pricey, while we continued to hold the relatively bargain-priced Pharmerica.
- Bradford Evans, CFA, is a portfolio manager at Heartland Advisors Inc. in Milwaukee.
