Help with EV and EBITDA material
So I'm going through some IB prep materials and I came across an idea I'm struggling to comprehend.
Basically let's create a situation where there are two companies A and B
Company A has EV / EBITDA = 10x and EV / Revenue = 2x
Company B has EV / EBITDA = 20x and EV / Revenue = 2x
This would mean that Company A has EBITDA / Revenue = 0.2, while Company B has EBITDA / Revenue = 0.1 (i.e. the EBITDA margin)
My question is why does Company B have the higher EBITDA multiple of 20 versus 10 when it has a lower EBITDA margin?
The study guide I am going through said that if there are two companies that are 100% comparable, the reason why one might trade at a premium (higher EV / EBITDA multiple) would be either because one has higher revenue growth or a higher EBITDA margin which makes sense to me.
Yet in my situation this doesn't seem to be the case?
I'm definitely sure that I went wrong somewhere and I think it has to do with the fact that I assumed both had the same EV / Revenue but I don't know why that would make a difference when both are the same ratios.
Please help, it's making me go mad.
Could be that the companies are in different industries. Those ebitda multiples are driven off of comps, so one company must be higher valued than the other
But here we're assuming they are basically identical, including industries. I'm just wondering if the statement that higher EBITDA margins == higher EBITDA multiple (with all else being equal) is misleading which seems counter-intuitive
All else being equal, higher EBITDA margins mean a higher valuation (Think about it: higher profitability -> higher cash flows -> higher DCF valuation -> premium to similar but less profitable comps).
However, at a given valuation, lower EBITDA means a higher multiple (simple math)
to answer directly, simple math again, all else equal (including EV), higher margins = higher ebitda = higher denominator = lower multiple
You are kind of looking at it backwards. higher EBITDA margins == higher EBITDA multiple == higher EV is a true statement. If a company produces less EBITDA with the same Revenues then you will have to command a higher multiple to get the same valuation.
In the example you set forth you are holding EV constant and in the real world this doesn't hold true. EV will shift and that should adjust the multiples appropriately.
Multiples are more or less an application of the Gordon growth model where asset value is a function of its risk, growth, and current earnings profile (substitute earnings with ebitda, ebit, fcf, all of which can be a proxy for cashflow):
Value = CF(1)/ (r-g)
Thinking of it that way, how does margin affect risk and growth? What other factors might affect risk and growth, and how could those have a greater impact than margin?
Can you expand on what you mean by margin affecting risk? As in a higher EBITDA margin would pay off the interest expense whereas a lower margin might not - is that the sort of thing you’re talking about?
Based on your question, I think you need to go back and review some of the basics first. Theoretically, TEV shouldn't be impacted by interest expense right? Let's start with the basics, if I have two assets that are paying the same amount of cash right now
That's all the equation I posted is telling you. That if current cashflow profiles are equal, then you can boil everything down to risk and growth. Now for higher margins, it's not immediately evident where that goes right? Theoretically it could go into risk, the idea is that higher margins might indicate higher pricing power (maybe more inelastic demand), so when the economy turns south, the Company might not have to cut prices as much. That would make the Company less risky indicating a higher multiple. Similarly, higher margins could be coupled with less operating leverage (all else being equal), so top line hits during downturns might impact the bottom line less making the Company less risky. Maybe you could argue that higher margins than comparable industry peers indicate a premium product that has greater growth potential.
The point is that for the purposes of an interview, you need to be able to clearly explain how a characteristic might impact valuation, and you need to be careful with something like margins, because it's not immediately obvious how two companies with the same ebitda, and different margins would trade at different multiples
Multiples are strictly determined mathematically by profitability, risk, and growth. Usually we assume a fixed rate of return prior.
Multiple = (fwd fcf/ebitda)/(r-g)
So the multiple is basically a profitability metric divided by growth adjusted risk.
Higher profitability -> higher multiple
higher growth -> higher multiple (lower denominator)
Ut in reprehenderit non odio et. Veritatis amet sed natus in qui commodi.
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