MSC Industrial Direct Company, Inc. (NYSE: MSM) shares currently trade at 12.4x its trailing EBITDA which is higher than the Industrials sector median of 11.7x. While this makes MSM look like a stock to avoid or sell if you own it, 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.
MSC Industrial 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 MSC Industrial’s EV / EBITDA ratio to its peer group that includes Applied Industrial Technologies, Inc. (NYSE: AIT), W.W. Grainger, Inc. (NYSE: GWW), NOW Inc. (NYSE: DNOW) and MRC Global Inc. (NYSE: MRC).
Since MSC Industrial’s EBITDA multiple of 12.4x is lower than the median of its peers (18.3x), it means that investors are paying less than they should for each dollar of MSM’s EBITDA. As such, our analysis shows that MSM represents an undervalued stock. In fact, finbox.io’s EBITDA Multiples Model calculates a fair value of around $107.50 per share which implies roughly 14.5% upside.
I selected a fair multiple of 14.2x in my analysis by averaging MSC Industrial’s current EV / EBITDA ratio with its peer group and sector.
Are Comps Really Comparable?
Before concluding that MSC Industrial 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 MSC Industrial, 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 MSC Industrial 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, MSC Industrial’s lower multiple may be because firms in our peer group are being overvalued by the market.
How This Impacts Shareholders
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 MSM. 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 MSC Industrial by taking a look at the following:
Valuation Metrics: what is MSC Industrial’s free cash flow yield and how does it compare to its publicly traded peers? This metric measures the amount of free cash flow for each dollar of equity (market capitalization). Analyze the free cash flow yield here.
Risk Metrics: what is MSC Industrial’s cash ratio which is used to assess a company’s short-term liquidity. View the company’s cash ratio here.
Efficiency Metrics: return on equity is used to measure the return that a firm generates on the book value of common equity. View MSC Industrial’s return on equity 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.