Sprouts Farmers Market Inc (NASDAQ: SFM) shares currently trade at 10.0x its trailing EBITDA which is lower than the Consumer Staples sector median of 12.8x. While this makes SFM 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.
Sprouts Farmers Market 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 Sprouts Farmers Market’s EV / EBITDA ratio to its peer group that includes Smart & Final Stores, Inc. (NYSE: SFS), Kroger Company (The) (NYSE: KR), SuperValu Inc. (NYSE: SVU) and Weis Markets, Inc. (NYSE: WMK).
Since Sprouts Farmers Market’s EBITDA multiple of 10.0x is higher than the median of its peers (6.8x), it means that investors are paying more than they should for each dollar of SFM’s EBITDA. As such, our analysis shows that SFM represents an overvalued stock. In fact, finbox.io’s EBITDA Multiples Model calculates a fair value of around $15.50 per share which implies roughly 29.5% downside.
I selected a fair multiple of 7.5x in my analysis by averaging Sprouts Farmers Market’s current EV / EBITDA ratio with its peer group and sector.
Are Comps Really Comparable?
Before concluding that Sprouts Farmers Market 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 Sprouts Farmers Market, 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 Sprouts Farmers Market 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, Sprouts Farmers Market’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 SFM. 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 Sprouts Farmers Market by taking a look at the following:
Valuation Metrics: what is Sprouts Farmers Market’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 Sprouts Farmers Market 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 Sprouts Farmers Market’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.