Enterprise value multiples

hey guys, i have two questions regarding this issue from CFAI books. 1. Page 537, it says one possible drawback to use EV/EBITDA is that EBITDA will overestimate cash flow from operations if working capital is growing. what does that mean? why this multiple is related to CFO? 2.Page 541-542,example 35, solution to 3, WDC appears undervalued to other two companies, but it has higher ROIC and higher revenue growth, which i think is contrary to the undervaluation. why the book says these two factors support undervaluation?? Any thoughts will be apprecaited!!

  1. The text notes that there are several alternative calculations for cash flow: Simple cash flow: EPS + depreciation Operating cash flow Free cash flow (FCFF or FCFE) And, EBITDA, which can be essentially viewed a cash flow measure before the ‘ITDA’ items. My understanding is: If you use EBITDA as a proxy for CFO, it will overstate CFO when working capital is increasing, since EBITDA is based on income statement items, while working capital is based on balance sheet items. EBITDA will not capture the increase in working capital investment. 2) Undervaluation isn’t based only on sales growth or ROIC - you have to look at those in conjuction with the price the security currently trades at, relative to other sector companies. WDC trades at TIC/EBITDA and EV/EBITDA multiples that are lower vs NTAP and EMC - in other words, each ‘unit’ of EBITDA costs less. So one would suspect that the shares are undervalued - if WDC was expected to see slower growth or lower profits, then one would assume that was the reason behind the lower multiples. But actually WDC has *higher* revenue growth and ROIC, and we’d normally expect stocks with better growth prospects to trade at higher multiples. Investors should be willing to pay more for a faster-growing company vs a slower-growing company. Although we’d need to dig further to see if there are other factors that is causing the shares to trade at lower multiples, the lower multiples plus higher revenue growth and higher ROIC all point towards undervaluation.

good explanation samurai. For #1, EBITDA just doesn’t show working cap investment therefore cash flow is overstated.

thanks samurai, fantastic explanations!