For the third article of the series, I will discuss the payback period and how to use it in value investing. I’ll refer to this article for terminology so it might be handy if you keep it opened in another tab.
Payback period is an important concept in value investing. Payback period tells us how long it will take for you to recuperate the cost of your investment to return its cost. For example, say you buy a $1M house which gives you $100K return annually as an investment, then payback period of such investment is 10 years ($1,000,000 divided by $100,000). In general, I would say an investment is attractive if the payback period is less than 10 years and is expected to generate cash for longer than 10 years.
When purchasing stocks, the general idea is similar to the housing example above. You are buying a part of a company instead of a house. There are several metrics you can use to estimate a payback period of a stock.
- Price to Free Cash Flow (P to FCF)
Price to Free Cash Flow = Market Cap / Free Cash Flow
=> I use P to FCF if the company has a low level of debt and has a positive free cash flow. Market Cap is the price of company (total market value of the shares). The only problem with this metric is that it doesn’t incorporate the level of debt of the company. I only use these metrics for companies with low debt. Also, the metric is not very useful if the company has a negative free cash flow. Companies that are growing tend to have negative free cash flow due to investment in new technologies/facilities.
- Enterprise Value to EBITDA (EV/EBITDA)
EV/EBITDA = Enterprise Value / EBITDA
=> If the company has a negative free cash flow, I use EV/EBITDA instead.
- Enterprise Value to Free Cash Flow (EV to FCF)
EV/Free Cash Flow = Enterprise Value / Free Cash Flow
=> I rarely use this metric but I would use it if a company has a high debt and positive free cash flow. It gives you a better picture than P to FCF since the metric incorporates the size of the debt.
Let me briefly demonstrate how I use these metrics to identify overvalued and undervalued stocks.
For example, here is the EV/EBITDA of Tesla as of today (Dec 23, 2016). Data retrieved from Gurufocus.com
Intuitively, we can say that it takes 372 years for Tesla to return its cost with its earning power today. Even if its earnings grow 10 times, it still takes more than 30 years to get the investment back. If this is not an overvaluation, I’m not sure what is.
Now, let’s look at Fitbit as a comparison.
Intuitively, it only take 4.43 years for Fitbit to payback the investment if you buy the shares at the price today ($7.29 as of Dec 23, 2016). In other words, you could get your money back within 5 years and get returns thereafter if the company’s earning remains stable. In fact, Fitbit’s revenue is growing at an exponential pace so the payback period could be even shorter. This is the kind of stock I’m interested in buying.
The metrics, P to FCF, EV/EBITDA, EV/FCF give you rough idea of the payback period of your investment. Smaller these metrics are (except when they are negative), the stocks are more likely undervalued. My general advice is to pick stocks which have payback period of less than 10.