Cognizant Technology Solutions Corp (NASDAQ: CTSH), an information technology firm with a market capitalization of $44.2 billion, currently trades at an EBITDA Multiple of 13.6x which is below the sector’s median multiple of 15.7x. Although this makes CTSH look attractive, investors may change their mind after reviewing the assumptions behind the EV / EBITDA ratio. In the post below, I calculate Cognizant’s fair value using an EBITDA Multiples valuation.
How To Interpret Cognizant’s EBITDA Multiple
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 companies deemed to be similar. We can then determine if a company is undervalued or overvalued relative to its peers by comparing metrics like growth, profit margin, and valuation multiples.
EV / EBITDA, also known as Enterprise Value-to-EBITDA Multiple or an EBITDA Multiple, measures the dollars in Enterprise Value for each dollar of EBITDA. 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
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 Cognizant’s EV / EBITDA ratio to its peer group that includes DXC Technology Company (NYSE: DXC), Leidos Holdings, Inc. (NYSE: LDOS), Booz Allen Hamilton Holding Corporation (NYSE: BAH) and Infosys Limited (NYSE: INFY).
Since Cognizant’s EV / EBITDA ratio of 13.6x is higher than the median of its peers (12.2x), it means that investors are paying more than they should for each dollar of CTSH’s EBITDA. As such, our analysis shows that CTSH represents an overvalued stock. Furthermore, finbox.io’s EV / EBITDA Ratio Model calculates a fair value of roughly $67.50 per share which implies around 10.5% downside.
I selected a fair multiple of 12.0x in my analysis by averaging Cognizant’s current EV / EBITDA ratio with its peer group and sector.
EBITDA Multiple Flaws
While this approach typically provides a reasonable valuation range, it is important to understand that our conclusion rests on some important assumptions. The first being that the selected peer group actually contains companies that truly are similar to Cognizant. The second important assumption is that the selected peer group stocks are being fairly valued by the market.
If the assumptions above do not hold to be true, then the difference in EV / EBITDA ratios could be due to a variety of factors. For example, if you accidentally compare Cognizant 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, Cognizant’s higher multiple may be because firms in our peer group are being undervalued by the market.
What To Do Next
As a current investor, you may have already conducted fundamental analysis on the company and its stock so its current overvaluation could signal a potential selling opportunity to reduce your exposure to CTSH. But keep in mind the EV / EBITDA ratio’s potential flaws when applying this valuation approach. It is important to note that there are a variety of other fundamental factors that I have not taken into consideration in this article. I highly recommend that you continue your research on Cognizant by taking a look at the following:
Valuation Metrics: what is Cognizant’s price to book ratio and how does it compare to its peers? Analyze Price / Book here.
Risk Metrics: what is Cognizant’s CapEx coverage? This is the amount a company outlays for capital assets for each dollar it generates from those investments. View the company’s CapEx coverage here.
Efficiency Metrics: inventory turnover is a ratio that measures the number of times a company’s inventory is sold and replaced over the year. View Cognizant’s inventory turnover 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.