Why does a Low EV/EBITDA Multiple Make a Good Acquisition Target?
Read that EV/EBITDA multiple = good acquisition candidate...but why is this? What makes high EV/EBITDA not a good candidate?
And in general, is a company with a smaller ev/ebitda inferior or superior to rival company with higher ev/ebitda?
Thanks you
What is EV/EBITDA?
Enterprise Value / EBITDA is a metric that looks at the companies wholistic worth relative to a proxy for cash flow that is available to all investors.
Enterprise Value is calculated by Market Capitalization + Debt - Cash. This figure accounts for the entire capital structure - not just equity.
EBITDA is Earnings Before Interest Tax Depreciation and Amortization. Known as a proxy for free cash flow, EBITDA looks at the earnings generated through the operations of the business.
Why is a Low Enterprise Value to EBITDA Multiple Good?
As is often the case, it is relative to say that a low EV/EBITDA is a "better" investment or take out target. That being said, when comparing similar companies - a multiple that is lower than the industry average may imply that it is undervalued.
User @ampeypua" explained some caveats to this general rule:
Very generally speaking, a lower EV/EBITDA or P/E means you're spending less money for a $1 of earnings. So that's a good thing. But this is all very simplistic:A few exceptions include:
- A high growth company might have very low current earnings but huge upside and therefore will trade at a higher multiple
- Some companies are riskier (however you want to define risk) and thus warrant a lower multiple
- Some companies are cyclical and thus the current multiple is skewed by where the market thinks we are in an economic cycle.
- There's important line items underneath EBITDA such as reinvestment needs (WC needs, Capex, R&D etc). This will skew an EV/EBITDA calc.
Please see a good explanation of how this multiple is used to determine value below.
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It's all relative...you can't say that "low" EV/EBITDA is good and "high" EV/EBITDA isn't...
But what this means is if two companies have a similar EV, but Company B has a lower EV/EBITDA ratio than Company A, B obviously has a higher EBITDA (because you're dividing by a bigger number in the denominator). Theoretically this means a company has stronger cash flows and could be undervalued relative to the other company in this example.
Very generally speaking, a lower EV/EBITDA or P/E means you're spending less money for a $1 of earnings. So that's a good thing.
But this is all very simplistic: 1) A high growth company might have very low current earnings but huge upside and therefore will trade at a higher multiple
2) Some companies are riskier (however you want to define risk) and thus warrant a lower multiple
3) Some companies are cyclical and thus the current multiple is skewed by where the market thinks we are in an economic cycle.
4) There's important line items underneath EBITDA such as reinvestment needs (WC needs, Capex, R&D etc). This will skew an EV/EBITDA calc.
etc etc etc
Because it's cheap. No one cares how great the target is if it's too expensive to break even.
Great. Thanks everyone
EV/EBITDA (Originally Posted: 02/03/2011)
Hi all,
I've been having a debate over the usage of EV/EBITDA. I think it should be used to value companies with high depreciation/amortization charges so that you can get a more accurate picture of their earnings, but the person I was discussing with said the opposite and that if a co has high depreciation/amort you would want to factor that in and therefore use EV/EBIT. That sounds wrong to me.
Thanks,
It really depends case-by-case (which is why you will always see both EBITDA and EBIT multiples in comps), depending mainly on the co.'s industry, line of business, mgmt, etc., but I can see where your confusion lies. But think of it this way, if a co. has unusually high D&A charges, that is not a good proxy for its cash flow as obviously capex/upfront investment is greater as well. As Warren Buffett says, "References to EBITDA make us shudder — does management think the tooth fairy pays for capital expenditures? We're very suspicious of accounting methodology that is vague or unclear, since too often that means management wishes to hide something."
"Trumpeting EBITDA (earnings before interest, taxes, depreciation and amortization) is a particularly pernicious practice. Doing so implies that depreciation is not truly an expense, given that it is a "non-cash" charge. That's nonsense. In truth, depreciation is a particularly unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business. Imagine, if you will, that at the beginning of this year a company paid all of its employees for the next ten years of their service (in the way they would lay out cash for a fixed asset to be useful for ten years). In the following nine years, compensation would be a "non-cash" expense – a reduction of a prepaid compensation asset established this year. Would anyone care to argue that the recording of the expense in years two through ten would be simply a bookkeeping formality?"
https://docs.google.com/viewer?url=http://www.berkshirehathaway.com/200…
Very good point and nice example. Like beamer said, I think you have to look at each particular company individually to figure out what makes the most sense at the time.
Agree with the above-it's all situational. EBITDA controls for capital intensity and financing decisions. It's situational whether that makes sense. EBIT and EBT are also important and useful.
Steve Wynn has complained about EBITDA being used for a capex-intensive industry like hotels & gaming: http://www.bing.com/videos/watch/video/steve-wynn-on-ebitda/3xbfbryo
EBITDA-maintenance capex is a good way to compare the free cash flows across businesses with different capital structures. I dont understand why people complain about EBITDA not accounting for capex when you can just subtract maint. capex from the number. Pretty simple.
Your friend is right. EBITDA multiples are used widely in industries and sectors where depreciation is 1) not a core component and 2) relatively small. Think digital media (exclusively valued on EBITDA multiples). But for companies with large capital intensity, EBIT makes more sense because depreciation is an important component of the company's operations (whenever the actual capex happens, depreciation just evenly accounts for capital intensity). Remember that in the long run, depreciation approaches capex, so subtracting depreciation out basically accounts for the investments and maintenance of the machinery.
What the general concept behind EV/EBITDA multiple (Originally Posted: 01/17/2015)
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