BorgWarner Inc (NYSE: BWA) trades at an EBITDA Multiple of 7.6x, which is lower than the Consumer Discretionary sector median of 10.2x. While this makes BWA appear like a stock to add to your portfolio, you might change your mind after gaining a better understanding of the assumptions behind the EV / EBITDA ratio ratio. In this article, I will break down what an EBITDA Multiple is, how to interpret it and what to watch out for.
Understanding Valuation Multiples and EV / EBITDA
A multiples valuation, also known as a comparable companies analysis, determines the value of a subject company by benchmarking the subject’s financial performance against similar public companies (peer group). We can infer if a company is undervalued or overvalued relative to its peers by comparing metrics like growth, profit margin, and valuation multiples.
An EBITDA Multiple, also known as Enterprise Value-to-EBITDA Multiple (EV/EBITDA), 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. Furthermore, its key benefit over the P/E multiple is that it’s capital structure-neutral, and, therefore, better at comparing companies with different levels of debt. The general formula behind an EBITDA Multiples valuation model is the following:
Enterprise Value = EBITDA x Selected Multiple
An EBITDA multiple is not meant to be viewed in isolation and is only useful when comparing it to other similar companies. Since it is expected that similar companies have similar EV / EBITDA ratios, we can come to some conclusions about the stock if the ratios are different. I compare BorgWarner’s EBITDA multiple to those of Tenneco Inc. (NYSE: TEN), Delphi Automotive plc (NYSE: APTV), Dana Incorporated (NYSE: DAN) and Lear Corporation (NYSE: LEA) in the chart below.
Since BorgWarner’s EBITDA multiple of 7.6x is higher than the median of its peers (5.6x), it means that investors are paying more than they should for each dollar of BWA’s EBITDA. As such, our analysis shows that BWA represents an overvalued stock. In fact, finbox.io’s EBITDA Multiples Model calculates a fair value of roughly $37.50 per share which implies approximately 27.5% downside.
Note that the selected multiple of 5.8x in the analysis above was determined by averaging BorgWarner’s current EBITDA multiple with its peer group and sector.
Understanding the EV / EBITDA Ratio’s Limitations
Before jumping to the conclusion that BorgWarner 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 BorgWarner, 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 BorgWarner 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, BorgWarner’s higher multiple may be because firms in our peer group are being undervalued by the market.
What This Means For Investors
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 BWA. 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 BorgWarner by taking a look at the following:
Valuation Metrics: how much upside do shares of BorgWarner 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 BorgWarner’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 BorgWarner 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.