Value Investing Using The Enterprise Multiple

Value investing refers to investing in companies trading significantly below their historic averages and below the market. Cyclical companies, such as energy, materials, and metals and mining are considered to be value stocks during times when the cycle is in the bottom half. However, any company, regardless of industry, can be considered value at different points in the business cycle. Read on to find out how you can take advantage of value investing by using the enterprise multiple.

Valuing a Stock

Value stocks are characterized by low multiples, high payout ratios and strong yields. Common multiples, such as price to earnings (P/E), price to book (P/B), enterprise value (EV), earnings before interest, taxes, depreciation and amortization (EBITDA) or the enterprise multiple, are applied to ascertain the trading value of a stock. P/E looks at today's stock price relative to the earnings. P/B relates today's stock price to the book value of the company. The enterprise multiple takes into account a company's debt and cash levels in addition to its stock price and relates that value to the firm's cash profitability. Each of these multiples has flaws, but the enterprise multiple is the most encompassing and generally considered the most useful in analyzing the current valuation of a stock. High payout ratios indicate the firm is returning cash to the shareholder in the form of dividends, rather than re-investing the profits in the company. Strong yields, particularly free cash flow yield, determine the return to the shareholder after all the cash expenses for operating a business and investment in capital expenditures are spent.

Enterprise Value

Enterprise value is the total value of a company. Whereas multiples that use the stock price look only at the equity side of a stock, enterprise value includes a company's debt, cash and minority interests. It is calculated as market capitalization (stock price times shares outstanding) plus net debt (total debt minus cash and equivalents) plus minority interest. Investors use enterprise value to determine how debt financing, corresponding interest payments and joint ventures impact a company's value. (Read EV Gets Into Gear for more information on comparing companies with different capital structures.)

EBITA

EBITDA is calculated from the income statement. As the name implies, it is calculated as operating profit, adding back depreciation and amortization. Analysts and companies use this as a measure of the true cash operating profit of a company since depreciation and amortization are non-cash items and taxes and interest are not considered part of the operations of the company even though these two items impact earnings. (For further reading, see EBITDA: Challenging The Calculation.)

Measurements

Proper and optimal capital structure is the key to a company's ability to operate profitably and thus should be considered when valuing a stock.

EV is an appropriate way to measure the value of the entire company rather than just the stock price, which looks only at the equity market capitalization of the stock, ignoring the company's cash, minority interests and debt. The enterprise multiple compares the total value of a company relative to its cash profits. It is often more desirable than P/E because EBITDA is considered less manipulable than earnings and than P/B because it is a better measure of cash profitability than book value. However, it is not without its flaws. Consider using more appropriate multiples when valuing highly levered companies where debt servicing, long lived assets or book value drives profitability.

Stocks with an enterprise multiple of less than 7.5x based on the last twelve months (LTM) is generally considered a value. However, using a strict cutoff is generally not appropriate because this is not an exact science. Often investors will consider enterprise multiples below the market, the company's peers and its historical average of a stock as a good entry point. However, cyclical stocks usually have a wide dispersion between the peak (high) and trough (low). This creates the need to take the current multiple in context, including where the industry and company are in their cycle, the fundamentals of the industry, and the catalysts driving the stock relative to its peers. Considering these factors will determine whether the LTM multiple is inexpensive or expensive. (Discover the differences between stocks in different industries, in Cyclical Versus Non-Cyclical Stocks.)

Value Traps

Value traps are stocks with low multiples; this creates the illusion of a value investment, but the fundamentals of the industry or company point toward negative returns. (Check out Value Traps: Bargain Hunters Beware! for further reading.)

Investors tend to assume that a stock's past performance is indicative of future returns and when the multiple comes down, they often jump at the opportunity to buy it at such a "cheap" value. Knowledge of the industry and company fundamentals can help assess the stock's actual value. One easy way to do this is to look at expected (forward) profitability (EBITDA) and determine whether the projections pass the test. Forward multiples should be lower than current LTM multiples; if they are higher, it generally means the profits will be declining and the stock price is not reflecting this decline. Sometimes forward multiples can look extremely inexpensive. Value traps occur when these forward multiples look overly cheap but the reality is the projected EBITDA is too high and the stock price has already fallen, reflecting the market's cautiousness. As such, it's important to know the company's and industry's catalysts.

Conclusion
Investing in stocks requires knowledge of a company's fundamentals, assessing its peers and using a common denominator, such as the enterprise multiple. The enterprise multiple is a proxy for how inexpensive or expensive a stock is trading today based on past and expected cash flows. However using the enterprise multiple is not foolproof and even if a stock is cheap on a multiple basis, market sentiment may be negative.

To learn from the original value investor, read The Intelligent Investor Benjamin Graham.

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Disclaimer…The subject matters expressed above is based purely on technical analysis and personal opinions of the writer. it is not a solicitation to buy or sell.

5 Common Mistakes Young Investors Make

When learning any skill, it is best to start young. Investing is no different. Missteps are common when learning something new, but when dealing with money, they can have serious consequences. Investors who start young generally have the flexibility and time frame to take on risk and recover from their money-losing errors, but sidestepping the following common mistakes can help improve the odds of success. (In addition to this article, read Eight Financial Tips For Young Adults.)
Tutorial: 20 Investments To Know

1. Procrastinating

Procrastination is never good, but it can be especially detrimental while investing because the markets move so quickly. Good investment ideas are not always easy to find. If, after doing research, a good investment idea arises, it is important to act on it before the rest of the market takes note and beats you to it. Young investors can be prone to not acting on a good idea out of fear or inexperience. Missing out on a good idea can lead a young investor to two very bad scenarios:

1. The investor will revise his opinion upward and still purchase an asset when it is not warranted. Perhaps the investor rightly develops an opinion that an asset priced at $25 should be worth $50. If it moves up to $50 before he or she buys it, the investor may artificially revise the price target to $60 in order to rationalize the purchase.

2. The young investor will look for a replacement. In the previous example, the investor who failed to buy the asset that rose from $25 to $50 may quickly try to identify the next asset that will double. As a result, the investor might purchase another asset quickly, without doing the proper work and research, in order to try to make up for the previous "missed opportunity." (Young investors often find themselves with too many options and not enough money. Read more in Competing Priorities: Too Many Choices, Too Few Dollars.)

2. Speculating Instead of Investing

A young investor is at an advantage in his or her investing life. Holding the level of wealth constant, an investor's age affects how much risk an he or she can take on. So, a young investor can seek out bigger returns by taking bigger risks. This is because if a young investor loses money, he or she has time to recover the losses through income generation. This may seem like an argument for a young investor to speculate, but it is not.

Any young or novice investor will have an inclination to speculate if they do not fully understand the investment process. Speculation is often the equivalent of gambling, as the speculator does not necessarily have a reason for a purchase except that there is a chance that it may go up in value. This can be dangerous, as there are many experienced professionals waiting to take advantage of their less-experienced counterparts.

Instead of speculating and gambling, a young investor should look to invest in companies that have higher risk but greater upside potential over the long term. So, while a diversified portfolio of small-cap growth stocks would not be appropriate for an investor nearing retirement, a young investor is better equipped to take on that risk and can take advantage accordingly.

A final risk of speculation is that a large loss can scar a young investor and affect his or her future investment choices. This can lead to a tendency to shun investing altogether or to move to lower or risk-free assets at an age when it may not be appropriate. (For more insight, see Personalizing Risk Tolerance.)

3. Using Too Much Leverage

Leverage has its benefits and its pitfalls. If there is ever a time when investors have the ability to add leverage to their portfolios, it is when they are young. As mentioned earlier, young investors have a greater ability to recover from losses through future income generation. However, similar to speculation, leverage can shatter even a good portfolio.

If a young investor is able to stomach a 20-25% drop in his or her portfolio without getting discouraged, the 40-50% drop that would result at two times leverage may be too much to handle. The consequences of such a drop are similar to those resulting from a loss due to speculation: the young investor may become discouraged and overly risk averse for the rest of his investing life. (Want to learn more about leverage? See Leverage’s "Double-Edged Sword" Need Not Cut Deep for more.)

4. Not Asking Enough Questions

If a stock drops a lot, a young investor might expect it to bounce right back, but more often than not, it is down for good reason. One of the most important factors in forming investment decisions is asking why. If an asset is trading at half of an investor's perceived value, there is a reason and it is the investor's responsibility to find it. Young investors who have not experienced the pitfalls of investing can be particularly susceptible to making decisions without locating all the pertinent information.

5. Not Investing

As mentioned earlier, an investor has the best ability to seek a higher return and take on higher risk when they have a long-term time horizon. Investors have their longest time horizons, and therefore a high tolerance for risk, when they are young. Young people also tend to be less experienced with having money. As a result, they are often tempted to focus on how money can benefit them in the present, without focusing on any long-term goals (such as retirement). Spending money now instead of saving and investing can create bad habits and contribute to a lack of savings and retirement funds. (For more on this, read Young Investors: What Are You Waiting For?)

The Bottom Line

Young investors should take advantage of their age and their increased ability to take on risk. Applying investing fundamentals early can help lead to a bigger portfolio later in life. There are also many risks that a young/less-experienced investor will face when making decisions. Hopefully, avoiding some of the common mistakes above will help young people learn investing early and embark on a fruitful investing career. (If you're a parent looking to teach your child about investing, take a look at our article Teach Your Child About Investing.)

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Disclaimer…The subject matters expressed above is based purely on technical analysis and personal opinions of the writer. it is not a solicitation to buy or sell.

The 6 Most-Traded Currencies And Why They're So Popular

The forex market is the world's largest and most liquid market, with trillions of dollars traded on any given day between millions of parties. For those just getting started in the forex market, one of the first steps is to gain familiarity with some of the more commonly traded currencies and their popular uses in not only the forex market but in general as well. Let's take a look at several popular currencies that all forex observers should be acquainted with and some of the underlying traits and characteristics of each. (Learn about the forex market and some beginner trading strategies to get started. For more, see Forex Trading: A Beginner's Guide.)
TUTORIAL: Introduction to Currency Trading

1. The U.S. Dollar

First and foremost is the U.S. dollar, which is easily the most traded currency on the planet. The USD can be found in a pair with all the other major currencies and often acts as the intermediary in triangular currency transactions. This is all because the USD acts as the unofficial global reserve currency, held by nearly every central bank and institutional investment entity in the world. (For more, see Profiting From A Weak Dollar.)

In addition, due to the U.S. dollar's global acceptance, it is used by some countries as an official currency, as opposed to a local currency, a practice known as dollarization. As well, the U.S. dollar may be widely accepted in other nations, acting as an informal alternative form of payment, while those nations maintain their official local currency.

The dollar is also an important factor in the foreign exchange rate market for other currencies, where it may act as a benchmark or target rate for countries that choose to fix or peg their currencies to the USD's value. For instance, as of 2011, China has its currency, the renminbi, still pegged to the dollar, much to the disagreement of many economists and central bankers. Quite often countries will fix their exchange rates to the USD to stabilize their exchange rate, rather than allowing the free (forex) markets to fluctuate its relative value. (For more, see The Pros And Cons Of A Pegged Exchange Rate.)

One other feature of the USD that is important for novices in forex to understand is that the dollar is used as the standard currency for most commodities, such as crude oil and precious metals. So what's important to understand is that these commodities are subject to not only fluctuations in value due to the basic economic principals of supply and demand but also the relative value of the U.S. dollar, with prices highly sensitive to inflation and U.S. interest rates, which directly affect the dollar's value.

2. The Euro

Although relatively new to the world stage, the euro has quickly become the second most traded currency behind only the U.S. dollar. As well, the euro is the world's second largest reserve currency. The official currency of the majority of the nations within the eurozone, the euro was introduced to the world markets on January 1, 1999, with banknotes and coinage entering circulation three years later.

Along with being the official currency for most eurozone nations, many nations within Europe and Africa peg their currencies to the euro, for much the same reason that currencies are pegged to the USD- to stabilize the exchange rate..

With the euro being a widely used and trusted currency, it is very prevalent in the forex market, and adds liquidity to any currency pair it trades within. The euro is commonly traded by speculators as a play on the general health of the eurozone and its member nations. Political events within the eurozone can often lead to large trading volumes for the euro, especially in relation to nations that saw their local interest rates fall dramatically at the time of the euro's inception, notably Italy, Greece, Spain and Portugal. The euro may be the most "politicized" currency actively traded in the forex market. (For more, see Top 7 Questions About Currency Trading Answered.)

3. The Japanese Yen

The Japanese yen is easily the most traded currency out of Asia and viewed by many as a proxy for the underlying strength of Japan's manufacturing-export economy. As Japan's economy goes, so goes the yen (in some respects). Many use the yen to gauge the overall health of the Pan-Pacific region as well, taking economies such as South Korea, Singapore and Thailand into consideration, as those currencies are traded far less in the global forex markets.

The yen is also well known in forex circles for its role in the carry trade. With Japan having basically a zero interest rate policy for much of the the 1990s and 2000s, traders have borrowed the yen at next to no cost and used it to invest in other higher yielding currencies around the world, pocketing the rate differentials in the process. With the carry trade being such a large part of yen's presence on the international stage, the constant borrowing of the Japanese currency has made appreciation a difficult task. Though the yen still trades with the same fundamentals as any other currency, its relationship to international interest rates, especially with the more heavily traded currencies such as the greenback and the euro is a large determinant of the yen's value. (For more, see The U.S. Dollar And The Yen: An Interesting Partnership.)

4. The Great British Pound

The Great British pound, also known as the pound sterling is the fourth most traded currency in the forex market,. It also acts as a large reserve currency due to its relative value compared to other global currencies. Although the U.K. is an official member of the European Union, it chooses not to adopt the euro as its official currency for a variety of reasons, namely historic pride in the pound and maintaining control of domestic interest rates. For this reason, the pound can be viewed as a pure play on the United Kingdom. Forex traders will often base its value on the overall strength of the British economy and political stability of its government. Due to its high value relative to its peers, the pound is also an important currency benchmark for many nations and acts as a very liquid component in the forex market. (For more, see The Greatest Currency Trades Ever Made.)

5. The Swiss Franc

The Swiss franc, much like Switzerland, is viewed by many as a "neutral" currency. More correctly, the Swiss franc is considered a safe haven within the forex market, primarily due to the fact that the franc tends to move in a negative correlation to more volatile commodity currencies such as the Canadian and Australian dollars, along with U.S. Treasury yields. The Swiss National Bank has actually been known to be quite active in the forex market to ensure that the franc trades with a relatively-tight range, to reduce volatility and keep interest rates in line. (This is the relationship between the euro and the Swiss franc currency pairs. For more, see Forex: Making Sense Of The Euro/Swiss Franc Relationship.)

6. The Canadian Dollar

Last on our list we take a look at the Canadian dollar, also known as the loonie. The loonie is probably the world's foremost commodity currency, meaning that it moves in step with the commodities markets, notably crude oil, precious metals and minerals. With Canada being such a large exporter of such commodities the loonie is very volatile to movements in their underlying prices, especially crude oil. Traders often trade the Canadian dollar to speculate on the movements of these commodities or as a hedge to their holdings of those underlying contracts.

Additionally, being located in such close proximity to the world's largest consumer base, the United States, the Canadian economy, and subsequently the Canadian dollar is highly correlated to the strength of the U.S. economy and movements in the U.S. dollar as well. (For more, see Canada's Commodity Currency: Oil And The Loonie.)

The Bottom Line

As we have seen, every currency has specific features that affect its underlying value and price movements relative to other currencies in the forex market. Understanding what moves a currency and why is a pivotal step in becoming a successful participant in the forex market. (For more, see Using Pivot Points In Forex Trading.)

by Investopedia Staff

Investopedia.com believes that individuals can excel at managing their financial affairs. As such, we strive to provide free educational content and tools to empower individual investors, including thousands of original and objective articles and tutorials on a wide variety of financial topics.

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Disclaimer…The subject matters expressed above is based purely on technical analysis and personal opinions of the writer. it is not a solicitation to buy or sell.

How Gold Affects Currencies

Gold is one of the most widely discussed metals due to its prominent role in both the investment and consumer world. Even though gold is no longer used as a primary form of currency in developed nations, it continues to have a strong impact on the value of those currencies. Moreover, there is a strong correlation between its value and the strength of currencies trading on foreign exchanges. (For related reading, see Gold: The Other Currency.)
TUTORIAL: Commodities Introduction

To help illustrate this relationship between gold and foreign exchange trading, consider these five important aspects:

1. Gold was once used to back up fiat currencies.

As early as the Byzantine Empire, gold was used to support fiat currencies, or the various currencies considered legal tender in their nation of origin. Gold was also used as the world reserve currency up through most of the 20th century; the United States used the gold standard until 1971 when President Nixon discontinued it. (For more, see The Gold Standard Revisited.)

One of the reasons for its use is that it limited the amount of money nations were allowed to print. This is because, then as now, countries had limited gold supplies on hand. Until the gold standard was abandoned, countries couldn't simply print their fiat currencies ad nauseum unless they possessed an equal amount of gold. Although the gold standard is no longer used in the developed world, some economists feel we should return to it due to the volatility of the U.S. dollar and other currencies.

2. Gold is used to hedge against inflation.

Investors typically buy large quantities of gold when their country is experiencing high levels of inflation. The demand for gold increases during inflationary times due to its inherent value and limited supply. As it cannot be diluted, gold is able to retain value much better than other forms of currency. (For related reading, see The Great Inflation Of The 1970s.)

For example, in April 2011, investors feared declining values of fiat currency and the price of gold was driven to a staggering $1,500 an ounce. This indicates there was little confidence in the currencies on the world market and that expectations of future economic stability were grim.

3. The price of gold affects countries that import and export it.

The value of a nation's currency is strongly tied to the value of its imports and exports. When a country imports more than it exports, the value of its currency will decline. On the other hand, the value of its currency will increase when a country is a net exporter. Thus, a country that exports gold or has access to gold reserves will see an increase in the strength of its currency when gold prices increase, since this increases the value of the country's total exports. (For related reading, see What Is Wrong With Gold?)

In other words, an increase in the price of gold can create a trade surplus or help offset a trade deficit. Conversely, countries that are large importers of gold will inevitably end up having a weaker currency when the price of gold rises. For example, countries that specialize in producing products made with gold, but lack their own gold reserves, will be large importers of gold. Thus, they will be particularly susceptible to increases in the price of gold.

4. Gold purchases tend to reduce the value of the currency used to purchase it.

When central banks purchase gold, it affects the supply and demand of the domestic currency and may result in inflation. This is largely due to the fact that banks rely on printing more money to buy gold, and thereby create an excess supply of the fiat currency. (This metal's rich history stems from its ability to maintain value over the long term. For more, see 8 Reasons To Own Gold.)
exceptions.

5. Gold prices are often used to measure the value of a local currency, but there are
Many people mistakenly use gold as a definitive proxy for valuing a country's currency. Although there is undoubtedly a relationship between gold prices and the value of a fiat currency, it is not always an inverse relationship as many people assume.

For example, if there is high demand from an industry that requires gold for production, this will cause gold prices to rise. But this will say nothing about the local currency, which may very well be highly valued at the same time. Thus, while the price of gold can often be used as a reflection of the value of the U.S. dollar, conditions need to be analyzed to determine if an inverse relationship is indeed appropriate.

The Bottom Line

Gold has a profound impact on the value of world currencies. Even though the gold standard has been abandoned, gold as a commodity can act as a substitute for fiat currencies and be used as an effective hedge against inflation. There is no doubt that gold will continue to play an integral role in the foreign exchange markets. Therefore, it is an important metal to follow and analyze for its unique ability to represent the health of both local and international economies. (This article explores the past, present and future of gold. For more, see The Midas Touch For Gold Investors.)

by Kalen Smith

Kalen Smith is a frequent contributor to the Money Crashers personal finance blog and writes about financial topics like investing in the stock market, insurance options, saving for retirement, and behavioral finance theory. Kalen holds an Master of Business Administration degree in finance from Clark University in Worcester, Mass.

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Disclaimer…The subject matters expressed above is based purely on technical analysis and personal opinions of the writer. it is not a solicitation to buy or sell.