What exactly does EV/EBITDA or any of the EV valuation ratios represent? For example, P/E means that you're paying X dollars for every dollar of a company's earnings. Does this apply with the EV ratios too? So for example if a company has a EV/EBITDA of 10x, you're paying $10 for every dollar of that company's EBITDA and it would essentially take 10 years for you to recoup your initial investment.
I got this question in an interview a while back and it kind off threw me off guard. Any answers would be much appreciated.
EBITDA is an approximation for operating cash flow. Not quite correct to say you recoup your investment in 10 years if you pay 10x because:
EBITDA isn't free cash flow, you still have outflows of capex, interest, tax, debt repayments, etc
EBITDA theoretically will increase over time, so you're paying 10x today, but maybe a 7 or 5x next year.
EV/EBITDA multiples are helpful because its a standard valuation scheme that ignores cap structure and capital expenditure strategy, both which can be changed upon a new equity sponser (e.g. PE firm) entering the business.
Then if thats the case, what exactly are you paying for on a dollar to dollar basis? I understand that its incorrect to say that you're going to recoup your investment in X years, but are still basically paying $10 (initially) for a dollar of EBITDA with a multiple of 10x?
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