Leidos Holdings Inc (NYSE: LDOS) trades at an EBITDA Multiple of 13.2x, which is lower than the Information Technology sector median of 15.9x. While this makes LDOS 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 Leidos Holdings Inc’s EBITDA multiple to those of Booz Allen Hamilton Holding Corporation (NYSE: BAH), CACI International, Inc. (NYSE: CACI), DXC Technology Company(NYSE: DXC) and CGI Group, Inc. (NYSE: GIB) in the chart below.
Since Leidos Holdings Inc’s EBITDA multiple of 13.2x is higher than the median of its peers (11.8x), it means that investors are paying more than they should for each dollar of LDOS’s EBITDA. As such, our analysis shows that LDOS represents an overvalued stock. In fact, finbox.io’s EBITDA Multiples Model calculates a fair value of roughly $50.50 per share which implies approximately 15.5% downside.
Note that the selected multiple of 11.6x in the analysis above was determined by averaging Leidos Holdings Inc’s current EBITDA multiple with its peer group and sector.
Understanding the EV / EBITDA Ratio’s Limitations
Before jumping to the conclusion that Leidos Holdings Inc 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 Leidos Holdings Inc, 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 Leidos Holdings Inc 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, Leidos Holdings Inc’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 LDOS. 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 Leidos Holdings Inc by taking a look at the following:
Valuation Metrics: what is Leidos Holdings Inc’s EBITDA less CapEx multiple and how does it compare to its peers? This is a helpful multiple to analyze when comparing capital intensive businesses. View the company’s EBITDA less CapEx multiple here.
Risk Metrics: what is Leidos Holdings Inc’s asset efficiency? This ratio measures the amount of cash flow that a company generates from its assets. View the company’s asset efficiency here.
Efficiency Metrics: is management becoming more or less efficient in creating value for the firm? Find out by analyzing the company’s return on invested capital ratio 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.