Textron Inc. (NYSE: TXT), an industrials business with a market capitalization of $17.7 billion, currently trades at an EBITDA Multiple of 12.1x which is above the sector’s median multiple of 11.7x. Although this makes TXT look unattractive, investors may change their mind after reviewing the assumptions behind the EV / EBITDA ratio. In the post below, I calculate Textron’s fair value using an EBITDA Multiples valuation.
How To Interpret Textron’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 Textron’s EV / EBITDA ratio to its peer group that includes General Dynamics Corporation (NYSE: GD), Raytheon Company (NYSE: RTN), L-3 Communications Holdings, Inc. (NYSE: LLL) and Northrop Grumman Corporation (NYSE: NOC).
Since Textron’s EV / EBITDA ratio of 12.1x is lower than the median of its peers (15.1x), it means that investors are paying less than they should for each dollar of TXT’s EBITDA. As such, our analysis shows that TXT represents an undervalued stock. Furthermore, finbox.io’s EV / EBITDA Ratio Model calculates a fair value of roughly $85.00 per share which implies around 23.0% upside.
I selected a fair multiple of 14.5x in my analysis by averaging Textron’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 Textron. 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 Textron 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, Textron’s lower multiple may be because firms in our peer group are being overvalued 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 undervaluation could signal a potential buying opportunity to increase your position in TXT. 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 Textron by taking a look at the following:
Valuation Metrics: how much upside do shares of Textron have based on the Ben Graham Formula? Take a look at our Ben Graham Formula data explorer which also compares the company’s upside to its peers.
Risk Metrics: what is Textron’s Altman Z score? It’s a famous formula used to predict the probability that a firm will go into bankruptcy within two years. View the company’s Altman Z score here.
Efficiency Metrics: how much free cash flow does Textron generate as a percentage of total sales? Has it been increasing or decreasing over time? Review the firm’s free cash flow margin 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.