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The stock market rises over the long run, with periodic setbacks that can last days, months or even years. (Thinkstock)

The stock market rises over the long run, with periodic setbacks that can last days, months or even years.

(Thinkstock)

INVESTOR CLINIC

Should I sell now and buy back in after the correction? Add to ...

Stocks have been going straight up all year and there is talk of a correction. Would you advise selling now and waiting for the market to drop before buying back in?

True, a lot of people have issued warnings about a correction.

Strategists at Goldman Sachs, for example, cited “the risk of a 10-per-cent drawdown.” Technical analysts at Phases & Cycles cautioned that “chasing the markets at this point is high risk.” And CMC Markets warned that stocks are “highly vulnerable to a correction.”

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Only problem is, those first two quotes appeared in The Globe and Mail back in January, and the third was published more than a year ago, in June of 2013. If you’d sold based on those warnings, you would probably be kicking yourself today: The S&P/TSX composite index has gained 12 per cent so far in 2014 and it’s up 21 per cent over the past 12 months – more if you include dividends.

Selling would make sense if you knew for sure that a correction was coming. But you don’t. Nobody does. Even if you did, how would you know when to get back in? The only thing we know for sure is that the stock market rises over the long run, with periodic setbacks that can last days, months or even years.

Trying to time those setbacks is asking for trouble. I have never known anyone who can do it reliably, although plenty of people try.

A better strategy is to buy and hold solid, blue-chip companies or low-cost index funds and stop worrying about the market’s short-term moves. If you keep some cash on hand and the market does tank, you can pick up some bargains. That way, you’ll be using the downturn to your advantage.

I often see the term EV/EBITDA in investing articles. Can you explain in layman’s language what it means?

EV/EBITDA is the ratio, or multiple, of enterprise value (EV) to earnings before interest, taxes, deprecation and amortization (EBITDA). A cousin of the price-to-earnings multiple, EV/EBITDA is used to determine whether a stock is cheap or expensive relative to other companies in the same industry. It’s also used to value takeover deals.

Let’s break down each of the ratio’s components.

EV is a measure of a company’s total value. It includes both the company’s market capitalization (number of common shares multiplied by market price) plus its outstanding debt. By adding the market cap (or equity) and debt together, you get a theoretical value that a buyer would pay for the business, before any takeover premium. The reason debt is included is that the buyer will be assuming those obligations.

As an analogy, think of a home with a mortgage on it. The EV is what the home would fetch in a sale. The debt is the value of the mortgage. And the equity is what the seller would pocket after paying off that mortgage.

The actual definition of EV is a bit more complicated and includes the value of preferred shares and a few other items. Also, any cash on the company’s books would be subtracted from EV, since it effectively reduces the buyer’s cost to acquire the company.

Now to the second component of the ratio: EBITDA

EBITDA is a measure of profit that excludes items (interest, taxes, depreciation and amortization) that aren’t directly related to the company’s core operations. The idea with EBITDA is to get at the heart of what the business actually earns in cash before exogenous factors such as financing decisions, accounting adjustments and government taxes muddy up the picture.

EBITDA is not an official accounting measure. However, analysts and investors often use the EV/EBITDA ratio – which is typically in the mid to high single digits – to compare valuations of companies in the same industry because it adjusts for differences in capital structures. Generally, a company with a lower EV/EBITDA ratio – all else being equal – would be considered a better value for an investor or a potential acquirer. The EV/EBITDA ratio should not be looked at in isolation; it’s also important to analyze other aspects of the business and industry.

 

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