Innospec Inc (NASDAQ: IOSP) trades at an EBITDA Multiple of 11.2x, which is higher than the Materials sector median of 10.3x. While this makes IOSP appear like a stock to avoid or sell if you own it, you might change your mind after gaining a better understanding of the assumptions behind the EV / EBITDA 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 Innospec’s EBITDA multiple to those of NewMarket Corporation (NYSE: NEU), Newpark Resources, Inc. (NYSE: NR), Ingevity Corporation (NYSE: NGVT) and Flotek Industries, Inc. (NYSE: FTK) in the chart below.
Since Innospec’s EBITDA multiple of 11.2x is lower than the median of its peers (15.3x), it means that investors are paying less than they should for each dollar of IOSP’s EBITDA. As such, our analysis shows that IOSP represents an undervalued stock. In fact, finbox.io’s EBITDA Multiples Model calculates a fair value of roughly $108.50 per share which implies approximately 42.0% upside.
Note that the selected multiple of 15.4x in the analysis above was determined by averaging Innospec’s current EBITDA multiple with its peer group and sector.
Understanding the EV / EBITDA Ratio’s Limitations
Before jumping to the conclusion that Innospec should be added to 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 Innospec, 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 Innospec with higher growth companies, then its EBITDA multiple would naturally be lower 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, Innospec’s lower multiple may be because firms in our peer group are being overvalued by the market.
What This Means For Investors
As a shareholder, you may have already conducted fundamental analysis on the stock so its current undervaluation could signal a potential buying opportunity to increase your position in IOSP. 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 Innospec by taking a look at the following:
Valuation Metrics: what is Innospec’s short ratio and how does it compare to its publicly traded peers? It represents the percentage of total shares outstanding that is being shorted. View the short ratio here.
Risk Metrics: how much interest coverage does Innospec have? This is a ratio used to assess a firm’s ability to pay interest expenses based on operating profits (EBIT). View the company’s interest coverage here.
Efficiency Metrics: fixed asset turnover is calculated by dividing revenue by average fixed assets. View Innospec’s fixed asset 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.