Knowles Corp (NYSE: KN) shares currently trade at 10.7x its trailing EBITDA which is lower than the Information Technology sector median of 16.0x. While this makes KN look like a stock to add to your portfolio, equity investors might change their mind after taking a closer look at the assumptions behind the EV / EBITDA ratio. In this article, I define how to calculate an EBITDA Multiple and what to keep an eye out for when applying it in a comparable companies analysis.
Knowles Corp Comparable Companies Analysis
A comparable companies analysis, also known as a multiples valuation, determines the value of a subject company by benchmarking its financial performance against similar public companies or peers. We can conclude if a company looks undervalued or overvalued relative to its peers by comparing metrics like growth, profit margin, and valuation ratios.
Enterprise Value-to-EBITDA Multiple, also known as the EV / EBITDA ratio or an EBITDA Multiple, measures the dollars in Enterprise Value for each dollar of EBITDA. To determine if a company is expensive, it’s far more useful to compare EV / EBITDA multiples than the absolute stock price. The general formula behind an EBITDA Multiples valuation model is the following:
Enterprise Value = EBITDA x Selected Multiple
The EV / EBITDA ratio by itself is not very helpful at all. It is only useful when comparing it to other companies that are considered similar to the subject company. The basic idea is that companies with similar characteristics should trade at similar multiples, all other things being equal. Therefore, we can come to a conclusion about the stock if the ratios are different. In the chart below, I compare Knowles Corp’s EV / EBITDA ratio to its peer group that includes AVX Corporation (NYSE: AVX), Fabrinet (NYSE: FN), Methode Electronics, Inc. (NYSE: MEI) and OSI Systems, Inc. (NASDAQ: OSIS).
Since Knowles Corp’s EBITDA multiple of 10.7x is higher than the median of its peers (8.6x), it means that investors are paying more than they should for each dollar of KN’s EBITDA. As such, our analysis shows that KN represents an overvalued stock. In fact, finbox.io’s EBITDA Multiples Model calculates a fair value of $9.85 per share which implies -14.5% downside.
I selected a fair multiple of 9.1x in my analysis by averaging Knowles Corp’s current EV / EBITDA ratio with its peer group.
Are Comps Really Comparable?
Before concluding that Knowles Corp should be banished from your portfolio, it is important to understand that our conclusion rests on two important assumptions.
(1) the selected peer group actually contains companies that truly are similar to Knowles Corp, and
(2) the selected peer group stocks are being fairly valued by the market.
If the first assumption is not accurate, the difference in EBITDA multiples could be due to a variety of factors. For example, if you accidentally compare Knowles Corp with lower growth companies, then its EBITDA multiple would naturally be higher than its peers since investors reward high growth stocks with a higher price.
source: EBITDA multiples model
Now if the second assumption does not hold true, Knowles Corp’s higher multiple may be because firms in our peer group are being undervalued by the market.
How This Impacts Shareholders
As a shareholder, you may have already conducted fundamental analysis on the stock so its current overvaluation could signal a potential selling opportunity to reduce your exposure to KN. However, keep in mind the limitations of an EBITDA multiples valuation when making an investment decision. There are a variety of other fundamental factors that I have not taken into consideration in this article. If you have not done so already, I highly recommend that you complete your research on Knowles Corp by taking a look at the following:
Valuation Metrics: how much upside do shares of Knowles Corp have based on the Ben Graham Formula? Take a look at our Ben Graham Formula data explorer which also compares the company’s upside to its peers.
Risk Metrics: what is Knowles Corp’s Altman Z score? It’s a famous formula used to predict the probability that a firm will go into bankruptcy within two years. View the company’s Altman Z score here.
Efficiency Metrics: how much free cash flow does Knowles Corp generate as a percentage of total sales? Has it been increasing or decreasing over time? Review the firm’s free cash flow margin here.
As of this writing, I did not hold a position in any of the aforementioned securities and this is not a buy or sell recommendation on any security mentioned.