Interview question over appropriate use of valuation multiples
Hi, recently finished an interview and was stumped by one of the question.
Between EV/EBITDA, EV/EBIT and P/E, under which circumstance would you use one multiple over another? Hypothetical if we were analysing 2 companies in the consumer/F&B sector, Company A being a manufacturing facility while Company B is just a distributor of the processed food, which multiple would you use to analyse each of the company and why?
My rationale when tackling this question was:
1) EV/EBITDA is more appropriate for asset-heavy companies as it excludes effects from D&A (such as depreciation policy) and capital structure (such that two companies of similar revenue size are valued on the same basis no matter the capital structure)
However, it got me to thinking:
1) Why do we want to exclude D&A? What if both companies have the same costs, but Company B has higher D&A. Does that not mean Company A has better returns on its prior capex, since it can generate the same level of profitability (pre-D&A) with lower historical capex?
2) Why do we want to exclude the effects of capital structure, by excluding interest expense? If both companies have the same EBITDA, but one significantly more levered, would that not be a cause for concern?
3) If EV/EBITDA is favoured for asset-heavy companies, why can't it be used for distributors too? Is there a reason a certain valuation multiple is favoured for asset-light companies?
4) To my understanding, even for asset-heavy companies, EV/EBITDA should also be used cautiously. One example is trucking companies, who periodically replace their whole fleet with huge amounts of debt. Hence, looking at EV/EBITDA right before it replaces the fleet would make the company seem severely undervalued. Is the correct course of action then to use P/E, a combination of both or an average multiple across the historical cycle?
There might be some flaws with my understanding, appreciate any guidance!
Based on the most helpful WSO content, here's a detailed breakdown of when to use different valuation multiples and how they apply to the hypothetical scenario of analyzing two companies in the consumer/F&B sector:
Valuation Multiples Overview:
EV/EBITDA:
EV/EBIT:
P/E:
Hypothetical Scenario Analysis:
Company A (Manufacturing Facility):
Company B (Distributor of Processed Food):
Addressing Specific Questions:
Why exclude D&A?:
Why exclude the effects of capital structure?:
Can EV/EBITDA be used for distributors?:
Use of EV/EBITDA for asset-heavy companies:
Conclusion:
This approach ensures that the valuation multiples used are appropriate for the specific characteristics and operational dynamics of each company.
Sources: Why even use EBITDA?, Why do P/E multiples and EBITDA multiples yield different valuation results?, DCF Modeling Course ~ Pre-training text.pdf, Secondary PE Modeling
You do not use EBITDA for asset heavy companies… CapEx is very real so adding it back does not make sense. Use EBIT.
I see so I got it mixed up.
So for asset-heavy companies (e.g. manufacturers), we should use EBIT to factor in the significant amount of capex?
In that case, why don't we use EBIT for asset-light companies too, since it is easier to calculate than EBITDA?
Asset light businesses D&A is obviously not a significant expense and usually isn’t contributing significantly to core business operations and also can be manipulated with accounting techniques so using EBITDA is a better proxy for cash flow to firm
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