Saint Petersburg School of Economics and Management Department of Management
Features of the market aspect of multiples, reflecting EBITDA and net income - EV / EBITDA and P / E. Disclosure as an important component of the company's strategy. Analysis of the telecommunications industry in Russia in terms of EBITDA and Net Incom.
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Saint Petersburg School of Economics and Management Department of Management
This bachelor thesis investigates the role of financial indicators EBITDA and Net Income as a companies' performance measures and examines the use or them for the prediction of companies' share prices. Although EBITDA is not established by IFRS or Russian GAAP as mandatory indicator to disclosure, EBITDA is widely used by analysts, investors and other stakeholders to assess the financial position and value of companies. Even though EBITDA is perceived as a measure that provides precise information about operations and does not consider the companies' assets financing, the Net Income indicator listed on an income statement already reveal all the necessary information without the need of adjustments (EBITDA). The bachelor thesis is aimed at evaluating EBITDA and Net Income indicator ability to predict share price for the telecommunication industry in Russian federation. The sample for the research consists of 5 public companies presented on the given market segment, which consist 80% of the industry's capitalization.
The research is done on the market-based method of multiples reflecting EBITDA and Net Income - EV/EBITDA and P/E. Each of the multiples were predicted for the four quartiles of 2018 by using regression analysis (Time Series Model). Then the companies' predicted share prices were extracted from the predicted multiples. As a result of the study, it was found that EBITDA predicts a share price better than Net Income indicator for the telecommunication industry in Russia.
Disclosure of various information, including financial data, is a crucial component of the company's strategy. The subsequent analysis and overview based on the financial information became public, allows both internal and external users related to a company, decide whether or not their interests might be served by it (Ivshin, 2019). Therefore, the disclosed information can be either mandatory or voluntary (Li & Yang, 2015). From the mandatory perspective, the company is obliged to disclose some financial information. However, companies are not able do decide upon the content of the financial report. Concerning the voluntary perspective, voluntary disclosure of information is optional by definition, and companies are supposed to gain a profit because of providing it (Folster, Camargo & Vicente, 2015).
EBITDA or Earnings Before Interest, Taxes, Depreciation, and Amortization is a voluntary financial metric to disclosure, used in analyzing the profitability of enterprises and showing the financial and managerial performance of companies. Historically, EBITDA indicator emerged in 1980s along with the practice of leverage buyouts (acquiring a company with the help of debts as the major source of financing the transaction), and has been used to determine a company's ability to service its debts. At the beginning, EBITDA was used by investors who consider the company from the perspective of set of assets that can be profitably sold separately, wherein EBITDA characterized the amount that can be used to repay debts. Afterwards, EBITDA was applied for evaluation of cash flows for companies that are close to the stage of bankruptcy and then for companies with long-term fixed assets (Stumpp et al., 2000).
Nowadays, even though EBITDA still does not include neither in IFRS nor in Russia GAAP, this tool of measuring performance became a frequently-used for various companies. It is one of the alternative means of communication with company's stakeholders along with such indicators as Net Income, operating income, operating cash flow etc. (Subramanyam, 2014).
However, some experts, for instance well-known entrepreneur Warren Buffett, tend to criticize EBITDA on the fact that indicator may inaccurately reflect the actual state of the company. Thus, extracting the depreciation and amortization, the external user has lack of information about the company's need for investment, and at the same time, companies with a high depreciation load may use this indicator in order to overestimate their financial result. Therefore, EBITDA should be considered in conjunction with other financial performance indicators (Ivshin, 2019).
Thus, EBITDA is a quite relevant and controversial indicator, which is possible to explore from different perspectives. Considering the prior studies on the topic of the thesis, it can be concluded that various authors have analyzed EBITDA from various perspectives. For instance, Alcalde, A. et al., (2013) consider the usefulness of EBITDA in terms of comparing the value for the different business sectors.
The objective of the bachelor thesis is to investigate and asses the ability of EBITDA to predict company's share price in comparison with other financial performance metric - Net Income, for the telecommunications segment of the Russian market - the business sector in terms of largest amounts of amortization. The tasks for the achieving the objective are:
· To define the average amount of fixed-assets used in telecommunication companies.
· To analyze the telecommunication market in terms of chosen companies.
· To collect manually all the data necessary to calculate following multiples.
· To calculate EV/EBITDA and P/E multiples reflecting EBITDA and Net Income accordingly for the public telecommunication companies.
· To create a regression model for both multiples in order to predict its values.
· To extract the predicted share prices based on the predicted values of multiples.
· To compare the predicted share prices with the actual ones.
Thus, the given research is empirical as the companies' financial data on the given market segment will be analyzed. One of the purposes of EBITDA is the ability to compare various companies operating in the same industry, since the amount of investments, the debt load or the tax regime used are not crucial. That's why it was decided to choose telecommunication industry, which is marked as a capital intensive one. The object of the research is the sample of telecommunication companies (representing the industry). The subject is the ability of EBITDA and Net Income to predict share prices for the given sample of companies.
The research question of the given bachelor thesis is the following: does EBITDA is able to predict company's share price more accurate in comparison with Net Income indicator for the Russian telecommunication industry? In other words, the usefulness and importance of EBITDA is determined not just as a general, but in the relevant industry, in which the use of EBITDA especially makes sense.
The hypothesizes for the research are:
H1. Telecommunication industry in Russia is a capital-intensive one.
H2. EBITDA is especially demanded by enterprises with high capital costs.
H3. EBITDA may accurate reflect the company's share price rather than Net Income.
In order to analyze the demand for EBITDA for the telecommunications industry, as well as to represent the comparative advantage of EBITDA over Net Income indicator, the largest companies in the telecommunications industry were taken. Financial data for the last 3 years by quarters (from 2015 to 2018) for 5 companies operating in the telecommunications industry were taken as primary data, on the basis of which EV/EBITDA and P/E multiples were calculated manually, as well as their intermediate indicators necessary for the calculation of these two multiples. Further, regression analysis (Time Series model) was implemented for each of the multiples, which predict the values of each multiple for their historical values. After the predicting the multiples, the share prices were extracted and compared with the actual ones.
The bachelor thesis has the following structure:
1. Abstract - the short description of the objective and main results of the bachelor's thesis. (1 page).
2. Introduction - the justification of the relevance of the work with an indication of the objective and task, research method and practical significance of the research. (3 pages).
3. Literature review - the observation of literature relevant to the topic of bachelor thesis. (9 pages).
4. Statement of the research question - the discussion of the literature review and its connection with the research question of the thesis, as well as the briefly description of the method used based on the tasks of the thesis. (3 pages)
5. Methodology - the description and justification of the chosen method for the research. (9 pages).
6. Description of the results - section of the thesis, where the results of the research are represented. (22 pages).
7. Conclusion - the summary of the literature review and the results of the research. (2 pages)
Total number of references in this bachelor thesis is: 34.
This paper may contribute to the financial scientific society due to obtaining information related to the disclosure of EBITDA in the Russian telecommunication companies' financial reports, analyzing its validity and relevance over Net Income indicator, identifying the accuracy of the data represented. The results of the thesis could be relevant for the investors and analysts, who will be able to obtain a clearer picture of the importance of the two indicators for the telecommunications industry and its ability to predict share prices.
This section of the bachelor thesis depicts the information concerning the concept of EBITDA, its disclosure in financial reports and various approaches to measuring company's performance with the help of EBITDA, as well as the possible limitations of EBITDA's usage. All these are serving as the theoretical base of the given bachelor thesis (Ivshin, 2019).
1.1 Disclosure and regulation of non-GAAP measures
There are a lot of literature about disclose of financial information, especially so-called non-GAAP measures. To begin with, it is worth to observe the existing studies and define several terms.
It is evident that all the companies operating in the stock market have to disclosure some financial information in order to demonstrate and provide transparent and valid information for the potential investors and other stakeholders (Phan Thi, 2019). It was noticed that evaluation of company's profitability, its vitality in terms of performance and risk level, can occur only on timely and reliable financial information. Thus, such information can be disclosed either on mandatory or voluntary basis. The disclosure of mandatory financial data is motivated by the requirement of the state's laws and regulations, whereas the disclosure of voluntary information is mostly aimed at providing additional data, which in turn will determine the increased interest to the company and consequently, result in a future increase in company's profitability (Venter, Emanuel, & Cahan, 2014).
EBITDA is an indicator provided by the companies on voluntary basis and it is not defined neither in IFRS (International Financial Reporting Standards) nor in Russian GAAP (Generally Accepted Accounting Principle). Thus, it is called as non-GAAP measure or alternative earnings measure. Black et al. (2017) discuss the widespread opinion that there is a trend to disclosure such non-GAAP measures, since nowadays they became more accurate, can grant additional valuable information for the external users. McKeon (2018) confirmed this finding by presenting the statistical data on growing trend reporting that in 2017, almost 97% of the S&P 500 The S&P 500 is a stock index consisting of 500 selected US stock companies with the highest capitalization. used at least one non-GAAP metric in their financial statement in comparison to 94% in 2015. Thus, the steady growth is observed.
Non-GAAP measures, as well as EBITDA, nowadays are regulated by US SEC (Securities and Exchange Commission). The SEC establish a classic formula for calculating EBIT and EBITDA indicators based on US GAAP statements. Therefore, EBITD/EBIT under SEC cannot be cleared from other expenses, except for taxes, interests, depreciation and amortization. (Deloitte, 2019). Indicators that are calculated in a different way cannot be called EBIT and EBITDA, therefore companies that deviate from the classical formula for one reason or another, call these indicators as “adjusted EBIT” or “adjusted EBITDA” (Mauboussin, 2018)
1.2 EBITDA and its criticism
SEC defines EBITDA as “earnings before interest, taxes, depreciation and amortization” Exchange Act Release No. 34-47226 (January 22, 2003), available at http://sec.gov/rules/final/33-8176.htm. , where “earnings mean Net Income as presented in the statement of operations under GAAP” and at the same time SEC clarifies that “operating income would not be considered the most directly comparable GAAP financial measure because EBIT and EBITDA make adjustments for items that are not included in operating income”. Non-GAAP Financial measures. U.S. Securities and Exchange Commission, available at: https://www.sec.gov/divisions/corpfin/guidance/nongaapinterp.htm
The other side of the coin of EBITDA is highly discussed in terms of unjustified extracting such crucial measures as taxes and significant expenses as amortization and depreciation. According to critics, the “income” and “operational cash flow” indicators more realistically reflect the financial state in companies, whereas EBITDA is an artificial and complex indicator (Stischek, 2001). Stumpp (2000) in the article listed ten most common directions for EBITDA's criticism. It is worth to mention several of them as they relate to the current study: (10) EBITDA cannot be used for the analysis of large amount of various business sectors as it does not take into consideration their unique attributes; (3) EBITDA does not take into account the quantity of needed investment -- particularly for corporations with short lived assets; (1) EBITDA does not take into consideration shifts in company's “working capital and overstates cash flow in periods of working capital growth”.
Among other possible, it is worth to mention such fact that the companies may change the basis for measuring and calculating EBITDA by using methods of calculation or adjustment, thus, management can manipulate the financial results of the company. Therefore, it is necessary to more thoroughly understand how the indicator was collected for the entire considered period. Likewise, enterprises with a high debt burden are in a better position, because if the firm has a large debt and pays high interest on it, EBITDA does not reflect this contribution. However, the profits of such a company will be inferior to companies with low debt, all other things being equal. The same situation is in the case of depreciation and amortization. EBITDA does not reflect the company's future investment needs. This suggests that when comparing companies from different spheres, for instance, production and services, companies with a larger share of fixed assets will benefit. Lastly, discussing limitations, it is worth to mention that EBITDA is the primary indicator for screening companies, after the initial inspection, the company requires more detailed study.
Taking the positive side of this indicator, it can be mentioned that it is believed that EBITDA fairly and accurately reflects the “cash profit” from the main activity of the company. Additionally, EBITDA is a convenient tool to use when comparing companies operating in the same industry. It does not matter the size of the investment, in terms of fixed assets, the size of the debt burden, as well as the mode of taxation of companies. In other words, when comparing companies, the tax rate of the country in which the company is located, the capital structure and accounting policies are not considered. Moreover, EBITDA is used not only in evaluating companies, but also in credit and financial analysis. EBITDA also allows to approximately estimate the amount of debt that a company can potentially overpower, as well it is also appreciating the investment opportunities. Lastly, the reliability of EBITDA when it is calculated is rather justified, because it does not allow any manipulations in the internal financial reporting items. For instance, if a company decided to increase depreciation, the net profit will decrease by the same amount and the depreciation will increase. Thus, only the structure of the indicator will change, but not the result.
1.3 EBITDA as a measure of company's performance
From the one perspective EBITDA can be considered as an indicator measuring operating cash flow. Again, it is partly true for the following reason: since EBITDA describes the company's “net” ability to generate operating income and does not include depreciation and amortization allows some experts to consider EBITDA from the point of view as it is analogue indicator of operating cash flows used when it is needed to conduct a quick financial analysis of the company (Sherman & Young, 2016). However, only average EBITDA for several years can be called a genuine approximation to the operating cash flows. The reality is that EBITDA only for one year does not consider changes in working capital, while operating cash flows reflect these changes. In addition, taxes not in the form of expenses in the income statement, but in the form of taxes paid can be the exact significant operating cash flow, which obviously cannot be ignored (Welc, 2017).
Another point to discuss is correlation between EBITDA and company's economic performance in terms of operating earnings. It can be investigated from the three perspectives: interest, tax, depreciation and amortization. The formal EBITDA includes all operating and non-operating earnings and expenses (excluding interest, taxes and depreciation), whereas operating earnings indicator does not include non-operating earnings and expenses. Non-operating (or non-operating) earnings or expenses are considered irregular or one-off income and expenses that are not related to the ordinary activities of the company. Operating profit is included in the calculation of another non-GAAP indicator - OIBDA (Operating Income Before Depreciation and Amortization). Thus, OIBDA contains only operating profit, whereas non-operating income and expenses are excluded.
1.4 EBITDA & Net Income
This part of the bachelor thesis is dedicated to the description of EBITDA and Net Income indicators, their practical significance, and the comparative side between these two indicators.
The financial indicator EBITDA (Earnings Before Interest, Tax, Depreciation and Amortization) is used to determine the ability of the organization to serve its obligations. This indicator is commonly used to estimate the operating results of the organization, as well it is perceived as a close metric to the operating cash flow, since the indicator does not include the costs of a non-cash items, for instance, such as depreciation and amortization (KPMG, 2018). Therefore, EBITDA illustrates the income of the organization, in other words, the revenue that the enterprise received in the reporting period and that can dispose it in the future (Cormier et al., 2016). Thus, thanks to this indicator, it is possible to assess the profitability of attracted investments and the level of self-financing reserve, as well as to track the formation of income at all stages. In addition, EBITDA can be used to compare companies with similarity in terms of activities and in terms of the company's size. Thus, two companies that are identical at the first glance may be significantly different in Net Income, while EBITDA of the comparing companies will be approximately equal. Such significant difference in can be explained by observing and analyzing the formation of company's income at all stages of its creation. Thus, if the EBITDAs of two companies are roughly equal, and the activity of the companies are identical, then the following analysis of how their income is formed is required (Bouwens, Jan & de Kok, 2019).
The formula of EBITDA's calculation, according to IFRS, is the following:
In the previous part of the literature review of the bachelor thesis, it was mentioned that EBITDA, despite its popularity, still does not defined by Generally Accepted Accounting Principles in Russia (Russian GAAP). Hence, EBITDA is not included in any standardized reporting form, such as the income statement, cash flow statement and the statement of company's financial results (Albring et al., 2013). Therefore, in order to proper calculate EBITDA value, it is worth to have other indicators: revenue, variable and fixed costs, labor costs, taxes (all these values must be cleared of VAT) and etc. Since EBITDA represents the received company's profit or loss, thus EBITDA should be placed in the statement of financial results or in the structure of company's income and expenses. A significant part of the required information is already contained in the relevant parts of these statements, but the obstacle in terms of EBITDA's calculation according Russian GAAP is the following: Russian GAAP it does not define depreciation and amortization as separate items in the financial statements, as it is already included there as part of cost's structure. Because of this fact, the financial statement is not sufficient thing allows to calculate EBITDA correctly. According to Barsky & Catanach (2014), financial reports prepared under IFRS should be supplemented with information about depreciation and amortization costs, which can be included in the explanatory note or in the other transcripts to the balance sheet.
It is also should be noted that the concept of depreciation adopted in Russian accounting, in foreign accounting is divided into two types: depreciation for tangible assets and amortization for intangible assets. Depreciation of tangible assets concerns only fixed assets or property, which have the duration of its useful over 12 months. Other tangible assets, such as inventories (assets), are not depreciated due to their short useful lives (Jennergren, 2018).
Intangible assets have amortization, but they are not always amortized: for instance, software licenses are amortized, whereas goodwill is not amortized. Amortization of an intangible asset depends on whether it has an end-of-life or not. Assets with definite useful life are subject to amortization, whereas assets with indefinite useful life are not.
Net Income is also one of the key financial indicators, which can be called as the main and the most important indicator of any organization. In the economic analysis, there are several types of Net Income, depends on which cost variable is included in the calculation of a certain type of Net Income, but in general, stakeholders, shareholders and investors are primarily interested in the overall company's Net Income (Cordazzo, 2013).
Net Income is a financial resource remaining at the disposal of the enterprise after all the necessary expenses of the enterprise have been made and all the mandatory payments have been paid to the state's budget. Moreover, upon the Net Income the owners of the company may decide whether or not to pay dividends and what amount of dividends should be paid and partially or fully to invest the amount of Net Income in the further development of the business. Thus, this indicator is one of the key financial metrics in assessing the performance of the company by external and internal users of financial information (Bataineh et al., 2016). Additionally, external users of company's financial information, for instance, investors or banks, are also primarily interested in Net Income, as it represents the overall profitability of the company. The formula for calculating Net Income is the following:
The major source of information about the company's performance for external users is the financial statement, since all revenues and expenses are included in the statement of financial performance and listed there. Moreover, the Net Income indicator can be observed in the balance sheet, but in order to extract the Net Income indicator from the company's balance sheet, the user of information should calculate the difference between the values of the indicator "Retained Earnings" for the similar reporting dates in the previous years. This difference will correspond to the Net Income for the period between these dates, but it should be noted that this method not always allows to correctly determine the company's Net Income. According to Gaudau (2015) it can be useful only in case when there was no any distribution of Net Income between the owners during the accounting period, or there were no other means of its use, for example, for the formation of various funds.
In other words, Net Income is one of the main indicators characterizing the performance of an organization. The way for its calculation includes all sources of revenues and expenses of the enterprise. Net Income represents the amount of money business owners can obtain after all mandatory payments are done. In the financial statements, Net Income is determined from the report dedicated to the company's financial results.
1.5 Equity value vs. Enterprise value
Enterprise value - it is the value of the company (enterprise), including all sources of financing: debt, preferred shares, minority interest and ordinary shares of the company. In a simple way, the formula for calculation includes Market Capitalization and Net Debt, since the other sources of financing may have small impact at the Enterprise Value.
In other words, the value of a company is an indicator reflecting the entire value of an enterprise that the investor should pay to fully acquire the company, including all assets and liabilities. According to Walters et al. (2002), Enterprise value is a more accurate valuation tool than the market capitalization, because it includes a few crucial factors such as preferred shares, debt, which includes bank loans and corporate bonds, and cash reserves that are excluded from the calculation. Market capitalization is calculated by considering the number of shares of common stock multiplied by the current share price. Taking investors into consideration, it can be said that investors will be more interested not in the value of the company's value (EV), but in its attitude to other important parameters reflecting the results of company's performance. When assessing the investment attractiveness of a joint stock company in terms of buying its shares, for instance, investors usually pay attention to such factor as EV/EBITDA, which will be discussed later.
Equity value is the sum of all the assets of an enterprise that it owns. The company's equity is usually used to form the share of assets, since company operates them in various transactions without any restrictions. The formula of equity value is the following:
Equity value represents what amount of the assets are financed by company's own funds. Its presence and value is one of the most important characteristics of financial stability of an enterprise. The equity value may decrease or increase depending on additional investments in the company, such as share issue income, gratuitously received values, as well as Net Income for the period, revaluation of fixed assets and others (Luo, Zhang & Duan, 2013).
The question for the further discussion is - why is it important to understand the difference between Enterprise value and Equity value? The answer is that these indicators should be compared with the corresponding indicators of income. For example, EBITDA, or earnings before taxes, interest and depreciation and amortization, contains income that is directed to pay interest on the debt, that is, the correct ratio is EV to EBITDA, but not Equity Value to EBITDA. In contrary, Earnings per Share, or the company's Net Income per share, for which interest on debt has already been deducted, is distributed to shareholders. Accordingly, the correct ratio will be P to EPS (Earnings per Share) or Equity Value to Net Income, but not EV to Net Income.
1.6 EV/EBITDA & P/E
This part describes two multiples EV/EBITDA and P/E that are used as the basis for the analysis of the telecommunication industry in Russia.
The EV/EBITDA multiple is the ratio of the company's value (Enterprise Value, EV) to its Earnings before interest, taxes, depreciation and amortization. EV/EBITDA ratio refers to the group of income multiples and represents the period for which unspent depreciation, amortization, interests and taxes of the company will pay back the cost of acquisition of an enterprise (Bodie Zvi et al., 2008). Thus, it provides an opportunity not only to compare the company with other firms in the industry and reveal the underestimation among them, but EV/EBITDA is also useful for finding the terminal value of the company in the DCF model. According to Damodaran (2012) EV/EBITDA is often compared with the P/E multiple, but in comparison, EV/EBITDA allows to compare enterprises with different debt and tax burden, and, subsequently, to abstract from the capital structure and features of taxation. In addition, EV/EBITDA is particularly useful in the evaluation of capital-intensive enterprises, where depreciation and amortization are the significant items. Sometimes, EV and EBITDA indicators cannot be found directly in the company's financial reports, thus the calculation of the multiple is more laborious than, for instance, more commonly-used market multiple - P/E.
It happens, that the company's management calculates the EBITDA value separately and uses it to illustrate the financial position of the company, publishing EBITDA in the annual reports directly or in transcripts to the financial reports. Moreover, the multiple should be used to compare companies from the same industry, because depending on the type of the business of the company and its specifics, the performance of multiples can vary significantly.
P/E ratio or “Price to Earnings per Share” is one of the most popular investment multiple, which represents the extent to which the company's shares are undervalued or overvalued for the potential investor (Zhou, Ping & Ruland, 2006). The popularity of this indicator is explained by the fact that it is quite easy to calculate and at the same time it immediately gives a proper overview of the attractiveness of shares. Multiple P/E means the ratio of “Price to Net Income”, as it shows how much investors pay for 1 monetary unit of Earnings (Net Income) per Share. There are two main types of P/E:
1. Trailing P/E, which is calculated based on Income data for the past 12 months. Thus, with each publication of the company's quarterly report, the time series is shifted to consider the new data.
2. Forward P/E, which is based on analysts' income forecasts for the next 12 months.
Accordingly, if the Forward P/E is lower than Trailing P/E, it means that the current evaluation of the company on the market is based on the expectations of increasing its income in the near future.
The main advantage of the P/E multiple is its simplicity of calculation and a large database for the comparison. However, the disadvantages of its use include the fact that P/E cannot be used in the case of evaluation of unprofitable companies. Moreover, P/E is not suitable for comparing companies from different countries and industries (Stimes & Wilcox, 2011). In addition, this multiple does not consider the differences in the capital structure between comparable companies, while interest on debt directly affects the amount of Net Income. Lastly, the value of Net Income is generally subject to significant random fluctuations, especially in cyclical companies where low P/E value can be sharply replaced by high ones when the growth stage changes, thus, such volatility can lead to erroneous distortion of the P/E results.
Summing it all up, it can be concluded that the main advantage of EV/EBITDA is the relative stability of this multiple because the manipulations with EV and EBITDA from the company's part are difficult to realize, since they are not depended on enterprises' accounting policies. In addition, EV/EBITDA is often used instead of P/E, if the company's Net Income is negative, since the EBITDA value is usually positive. EV/EBITDA is suitable for evaluating companies from capital-intensive industries, where depreciation and amortization are the significant amounts, as well as for comparing companies with different shares of fixed assets and depreciation, because it does not depend on the peculiarities of accounting policies in relation to the order of depreciation (Grant & Parker, 2001). Another important advantage of the EV/EBITDA ratio is that it allows to compare companies with different capital structures and financial leverage, as it eliminates the impact of the share of interest expenses on the financial result of the company. However, the disadvantage of the EV/EBITDA multiple is that the EBITDA's value, although it does not consider such non-monetary item of expenditure as depreciation (in comparison to Net Income in the P/E ratio), but still it is not a full-fledged indicator of company's cash flow at the disposal of shareholders.
2.Statement of the research question
This section of the bachelor thesis specifies the research question the thesis will focus on. In order to correctly identify the rationale for the formulated research question, it is necessary to identify all the main ideas and methods that were chosen in the current study, their development and the relation of this part of the bachelor thesis with the theoretical foundation.
As it was mentioned above, one of the aims of EBITDA is the ability to compare different companies operating in the same industry, since the amount of investments, the debt load or the tax regime used are not crucial. Thus, there is a trend of recent years is the evaluation of the company's activity based on EBITDA, which is calculated on the financial data represented under IFRS (McKeon, 2018). This financial indicator EBITDA reflects the amount of the company's earnings (income) before income tax, depreciation and amortization of fixed assets and intangible assets and interest on loans. EBITDA is mostly similar to the operating cash flow, since non-monetary cost items, such as depreciation, are excluded from it. Thus, EBITDA represents the income, i.e. the money that the company has earned in the current period and will be able to spend in the future. Hence, the owners of the business can make it possible to use this indicator to assess the return on investment and the self-financing reserve. It should be noted that EBITDA may be especially demanded by enterprises with large capital expenditures, for instance, companies providing telecommunication services, whose share of fixed assets can be up to 65% of the company's assets, and these companies have significant expenditures on depreciation and amortization (based on the data collected and explained in the following chapters).
Therefore, it is convenient for such enterprises to exclude depreciation and amortization in order to see the exact “picture” of current state of the enterprise. Thus, the first hypotheses - “Telecommunication industry in Russia is a capital-intensive one” - can be developed, since according to the primary data collected it is supposed that this industry is a capital-intensive one.
Based on the theoretical observation it became evident that investors and analysts pay much more attention to the EBITDA indicator than Net Income indicator. Thanks to EBITDA, external users of financial information may see whether the company has enough funds to subsequently invest in the expansion of its activities, pay dividends on shares or interest on loans. If the external user plans to determine the future cash flow of a company, for this purpose a “budget” for several years in advance is calculated. In this case, EBITDA will be the indicator, by discounting which, it is possible to calculate the company's ability to earn in the future (DCF model). Likewise, for instance, any banking organization deciding whether or not to issue a loan to the enterprise, will necessarily analyze EBITDA indicator to understand whether the firm will be able to pay off the loan. In addition, this indicator is often used when it is necessary to assess the position the enterprise occupies in its industry, and compare the company's activities with the activities of its competitors in a certain period (operating in the same industry). In this case, EBITDA is the most appropriate indicator of the current market position of the organization, rather than Net Income indicator.
The results of such a comparative analysis can be useful both for the external users of the financial information, for instance, potential investors, who choose the enterprise for the investment, and for the top management of the company itself, since right managerial decision can be made upon the use of EBITDA.
The core idea of the given bachelor thesis is to compare EBITDA and Net Income indicator by using market-based method of analyzing multiples, which were described above - EV/EBITDA and P/E (EPS) multiples. The enterprises of the telecommunication industry were selected for the further calculations. This choice was made in order to confirm or refute the 2nd hypothesis -EBITDA is especially demanded by enterprises with high capital costs. These multiples were applied to the telecommunication segment of the Russian market, as this segment, according to the Rosstat data has one of the highest levels of depreciation in the production cost. Telecommunication industry in the Russian Federation is one of the most rapidly developing and large-scale sectors of the national economy. According to the level of profitability, capitalization and volumes of tax payments to the budgets of different levels, the largest enterprises of the telecommunication market are - MTS, MegaFon, Vympel-Communications (VEON Group) and Rostelecom. Taking into consideration the factors influence the revenue, and as following the EBITDA and Net Income indicators, it can be noted that mobile services bring the largest share of revenue to telecommunication enterprises, but against the background of market saturation, new directions of development play an increasingly important role, including, first of all, digital services such as mobile TV, Internet, various system integration, e-Commerce and others. On the opposite, another indicator represents the growth - the growth rate of subscriber base gradually decreases. This trend can be associated with a gradual saturation of the market, and the concentration of mobile-operators resulting in the quality of the subscriber base (MegaFon, 2018).
As it was mentioned above, the analysis of EBITDA is justified, because EBITDA may be especially demanded by enterprises with large capital expenditures. The companies of the telecommunication industry in Russia were chosen based on the theoretical analysis.
In order to analyze the demand for EBITDA for the telecommunications industry, as well as to represent the comparative advantage of EBITDA over Net Income indicator, the largest companies in the telecommunications industry were taken. Financial data for the last 3 years by quarters (from 2015 to 2018) for 5 companies operating in the telecommunications industry were taken as primary data, on the basis of which EV/EBITDA and P/E multiples were calculated manually, as well as their intermediate indicators necessary for the calculation of these two multiples. Further, the regression analysis has been implemented (Time Series model) in order predict the values of each multiple for their historical values. According to the data obtained, it became evident that the regression of the EV/EBITDA multiple more accurately reflects the dependence of the previous year, followed by, while the P/E repression gives a less accurate forecast. Based on the obtained forecast values of the EV/EBITDA and P/E multiples, calculations were carried out, which allowed both multiples to lead to the share price. Further, the share price derived from the predicted EV/EBITDA multiple more accurately reflected the market price of the stock of those periods compared to the share price derived from the predicted values of the P/E multiple. Thus, it was found out that EBITDA more accurately reflects the companies' value than Net Income, and consequently, the companies' share prices.
This all information gathered contributed to the research question of the given bachelor thesis: does EBITDA is able to predict company's share price more accurate in comparison with Net Income indicator for the Russian telecommunication industry? It resulted, that EBITDA reflects the share price better that Net Income for the chosen telecommunication companies, thus, EBITDA better reflects the value of businesses in this market segment.
In order to identify the role of EBITDA in the financial statement and empirically describe the differentiation of EBITDA from Earnings, EBITDA will be assessed in comparison of Net Income indicator. The main aim of the given bachelor thesis is to evaluate the companies based on the EBITDA and Net Income predicative abilities of current Price per Share using Net Income and EBITDA indicators.
3.1 Approaches to business evaluation
The evaluation of business in the financial analysis serves two purposes: firstly, in order to acquire the company, secondly - buying shares of companies in order to earn in the future by receiving dividends from shares or by a positive change in share price. There are two main possible approaches of evaluation of companies.
The first approach supposes that the company's share is needed to be eligible for cash flows of an enterprise. In order to predict the share price, it is worth to determine the amount of money the company will make in the future. The share price is the discounting of company's future cash flows. Thus, when a company's share is bought, it is assumed that shareholder in the future will receive money from it. But the share price varies from year to year, thus it is needed to discontinue price of a share at some interest rate, what is called the method of Discounted Cash Flow (or DCF model). The DCF model is used to estimate the current value of an enterprise based on the principle that this value is able to generate cash flows. For this purpose, the cash flow is discounted, it means that the amount of future cash flows convert to its fair value in the present using a discount rate that is the required yield or price of capital (Sayed, 2016). The limitation of use of this method in the given bachelor thesis is the fact that it does not represent the comparison between EBITDA and Net Income, despite the fact that EBITDA is used in the DCF model in the form of multiple EV/EBITDA.
The second method is the Market-Based Method of Multiples. According to the Efficient Market Theory (or Efficient Market Hypotheses) all participants of a stock market have free and equal access to information regarding their investment opportunities. Therefore, market participants are able equally use all the information to identify the reasons that led to the analyzed security to its market value, as well as correctly predict its future dynamics. Thus, it is assumed that 2 identical assets (or enterprises) should cost roughly the same. Therefore, it is assumed that 2 identical companies, if they earn approximately the same amount of money and belong to the same industry, they should cost approximately the same, the market should evaluate them equally. Hence, bringing the Enterprise Value to single denominator, for example, EBITDA, it is supposed that the companies of the telecommunication industry can be compared, as well as Price to Earnings per Share. In other words, multiples are derived financial indicators by which potential investors evaluate the investment attractiveness of a business, it shows the relative characteristics of the business. Multiples are the basis of the value approach to investing, which offers to find and buy shares of undervalued companies.
3.2 The sample of the research
Thus, it was decided to choose multiples EV/EBITDA and P/E, which fully reflects the value of company with the use of proposed indicators - EBITDA and Net Income.
The primary sample for the analysis represents of 15170 telecommunication companies in Russian Federation. The number of the companies were extracted from the SPARK-Interfax by filtering the data through criteria of Russian National Classifier of Economic Activities (in Russian - ОQЭД, further - RNCEA). According to the Russian National Classifier of Economic Activities, the telecommunication companies are assigned the following RNCEA: № 61 “Activities in the field of telecommunications”, which include the sub-RNCEAs: № 61.1 “Activities in the field of communication on the basis of wired technologies”, № 61.2 “Activities in the field of communication on the basis of wireless technologies”, № 61.3 “Activities in the field of satellite communications”, № 61.9 “Other activities in the field of telecommunications”. Each of these listed RNCEAs has its own sub-category, but in general the companies in the telecommunication industry can be described as it has been presented above. Most of the companies have several RNCEAs at the same time, since these companies can carry out several activities at the same time.
In order to detect which indicator more accurately reflects the value of shares of companies in the telecommunications industry it was decided to compare the extracted data (Price per Share) form the predicted market-based multiples EV/EBITDA and P/E with the companies' actual stock prices based on the historical data in order to analyze the usefulness of EBITDA and Net Income indicator. For this purpose, the only public companies are relevant to analyze, since only for the public companies the calculation of P/E is possible. As it was mentioned above, P/E is the relation of company's Price per Share to its Earnings per Share, hence, only public companies have shares. Public company - usually it is a joint stock company, shares of which are traded on the stock market freely, without any restrictions. The national legislation on regulation of the stock market imposes certain requirements for disclosure of information on companies whose shares may be offered to purchase to an unlimited number of persons and listed to the stock market. Enterprises that meet these requirements are called public companies.
Thus, the sample has been reduced to the number of 177 public companies in the telecommunication industry. After the narrowing the sample, it was noticed that the major of the companies are parts of the group of companies, that is, they are subsidiaries. Thus, the list of companies represents that most of them are branches in the regions of Russia of large telecommunications companies in the industry.
The further observation showed that, nowadays, there are 5 public large companies represents the telecommunication industry - MTS, MegaFon, Vympel-Communications (VEON Group) and Rostelecom. These companies consist more than the two-thirds of the Russian telecommunication industry capitalization. Therefore, the such a small sample can be called as reliable one, since is can be sad that these 5 companies represent the whole telecommunication market in Russian Federation.
3.3 The primary calculations
Based on the assumption that EBITDA is relevant to use and calculate in case when a company receives a large part of its income using fixed assets for which it is obliged to charge monthly and annual depreciation, and therefore, the depreciation adjustment (EBITDA) gives a more realistic financial “picture” of the enterprise, it is necessary to determine the share of fixed assets in companies' assets. The formula for the calculation is the following:
Where fixed assets are the amount of fixed assets in terms of money (rubles) and total assets are the company's all assets in money in balance sheet. Based on this calculation, the share of fixed assets of each company for the 5-year period (from 2013-2018), it became evident the average amount of fixed assets, thus, these is a sense to use EBITDA.
After the defining the relevance of EBITDA for the chosen companies, the multiples EV/EBITDA and P/E were calculated. All the calculations were done manually, since it was not possible for all companies to find historical data of multiples for previous periods, as well as proper information concerning market capitalization of companies, the number of shares and other variables. Thus, it was decided to choose 3-year period of observation (2015, 2016, 2017 years) and to predict the EV/EBITDA and P/E values for the 2018 and to compare it with the actual values. All the financial data were hand collected from the either financial statements or annual reports, other financial data were calculated manually.
In order to calculate EV/EBITDA multiple is was necessary to collect the following data (to perform the following stages) concerning the values of this indicator:
1. The value of EBITDA is needed to calculate EV/EBITDA. This information was taken from the financial statements of the telecommunication companies prepared under IFRS.
2. In order to obtain EV value, it was necessary to have the data concerning companies' Market Capitalization of companies as well as Net Debt, since Enterprise Value is the sum of Net Debt and Market Capitalization....
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