The Valuation Multiples That Actually Matter

Weekly Issue

Every few months it becomes fashionable on Wall Street to crown some new valuation trick as the miracle measure of the moment. In practice most of these measures are deeply flawed, easily distorted, or flat out useless once you get away from the slide deck and into the real world. Serious investors in the Graham and Whitman tradition know that valuation only matters when you ground it in economic reality. You want measures that tell you what you are paying and what you are getting in terms of real business value not accounting smoke or marketing mirrors.

Three measures rise above the noise. Enterprise value to earnings before interest and taxes for operating companies. Price to tangible book value for financial companies. Price to net asset value for real estate investment trusts. Each one reflects the actual economics of that particular type of business. Each one keeps you anchored in the world of assets cash flow and downside protection. Each one fights the silliness that leads so many investors to overpay for stories instead of buying real value.

Let us start with enterprise value to EBIT. Most investors live and die on simple price to earnings ratios which is unfortunate because P E ignores the capital structure and the true economics of the business. Enterprise value forces you to look at the whole thing. You add the equity. You add the debt. You subtract the cash. Only then do you know what you are really paying for the business. EBIT gives you the cleanest measure of operating earnings before the accountants and the capital structure specialists start rearranging the furniture. It tells you what the business earns from doing what it does before interest costs and tax rates intervene.

This is why EV to EBIT is the single best multiple for valuing a non financial business. It reflects what a rational buyer would actually pay to own the entire company. Private equity firms live on this measure. Strategic acquirers use it to determine what they can afford without destroying the balance sheet. Deep value investors love it because it ties the value of the business directly to the cash producing engine. When EV to EBIT is low you are usually looking at a company with a depressed stock price relative to its real operations. When it climbs too high you are entering the land of wishful thinking and momentum driven pricing. Over long periods of time the best performing stocks are the ones that start with low EV to EBIT multiples and then surprise the world by doing what profitable companies do. They compound.

Financial companies are another universe entirely. Their product is money. Their inventory is money. Their raw material is money. Trying to use EV to EBIT or even classic P E ratios on a bank or an insurance company is like trying to use a thermometer to measure the growth of a tree. You are using the wrong tool.

That is where price to tangible book value comes in. Tangible book value strips out the goodwill and the accounting fluff. It leaves you with the real net worth of the institution. For a bank that means loans securities and cash on one side and deposits borrowings and capital on the other side. When you compare the share price to tangible book you learn whether you are paying more or less than the hard value of the company.

Price to tangible book value is the single best valuation multiple for financial stocks and especially banks because it ties directly to their economic reality. A bank that earns consistently high returns on tangible equity deserves to trade above tangible book. A bank that struggles to earn its cost of capital should trade below. During periods when markets get fearful or impatient you can often buy excellent banks at discounts to tangible book. Over time those discounts disappear as earnings accumulate and the valuation reverts to normal. The entire discipline of bank value investing from Marty Whitman to FJ Capital begins with P to TBV because it is the cleanest measure of downside protection and the deepest insight into the real franchise value of the institution.

Real estate investment trusts (REITs) operate in yet another economic world. They are asset holding companies. They collect rent. They maintain properties. They distribute income. Their balance sheets reflect the actual buildings they own and the financing they use to hold those buildings. The accounting rules for real estate create enormous distortions in reported earnings which makes PE ratios nearly meaningless for REITs. Funds from operations and adjusted funds from operations get you closer to the truth but not all the way.

This is why the price to net asset value ratio is the gold standard for REIT valuation. Net asset value is the market value of the underlying real estate minus the debt. It is what an informed buyer would pay for the buildings if the REIT were liquidated. When you pay 90 cents on the dollar for a REIT trading below NAV (which is the kind of deal we’re looking for in our REIT Portfolio) you are buying real estate at a discount without having to deal with tenants broken HVAC units or local zoning boards. When a REIT trades far above NAV you are paying for growth expectations and portfolio quality that may or may not justify the price. Price to NAV tells you your margin of safety. It tells you the replacement value of the assets. It tells you whether you are buying trophy properties at a bargain or paying a premium for hope.

In the end valuation is not complicated if you use the right lens. For non financial companies you start with EV to EBIT because it reflects the real earning power of the business. For banks and insurance companies you use price to tangible book because it measures true net worth and downside risk. For REITs you use price to NAV because the assets are the business and the business is the assets.

Once you start valuing companies this way you discover something wonderful. The market may get loud but the math never does. These measures keep you grounded. They keep you disciplined. They keep you buying real value when the crowd is off chasing whatever shiny object has captured the imagination this week. That is how you survive in this game and more often than not how you win.