EV/EBITDA

What is EV/EBITDA?

EV/EBITDA, or EV Multiple, is a financial ratio used to compare Enterprise Value to earnings before interests, taxes, depreciation & amortization (EBITDA) and is used to evaluate a company's valuation and financial performance.

This financial ratio is calculated by dividing the Enterprise Value (EV) by EBITDA, and it's one of the most popular EV multiples across industries.

It's well-known among investors and analysts because it provides a clearer picture of a company's value relative to its operating performance. Additionally, this metric is much less manipulated by capital structure decisions.

EV/EBITDA is an extrinsic valuation method used to compare the valuation of a company relative to its peers, or an apple-to-apple comparison.

Enterprise value represents the value of a company's core assets, taking into account its market capitalization (the total value of its outstanding shares) as well as its total debt, preferred stock, and minority interest, minus cash and cash equivalents. Essentially, it's the value an acquiring entity would have to pay to acquire the entire business.

Where EBITDA is a proxy for cash flows. It is the amount of a company's operating income after adjusting it for interests, taxes, depreciation, and amortization. This metric is often used to measure a company's profitability before accounting for non-operating expenses and accounting decisions.

Understanding EV/EBITDA

EV/EBITDA, is a valuation metric utilized in assessing a company's worth. It integrates various financial components, including debt, equity, and operational performance, offering a holistic view of a company's financial standing.

The formula is easy to remember, as indicated by its name:

EV to EBITDA = EV / EBITDA

As with other valuation metrics, the first thing to understand is what a "high" or "low" valuation is. It has been said that below 10x is considered healthy, but broadly speaking, some indices have averaged above that.

EV/EBITDA ratio can be interpreted as follows

• A lower Enterprise Multiple than the peers: Undervalued
• A higher Enterprise Multiple than the peers: Overvalued

A high or low EV/EBITDA multiple can be considered as "good" or "bad" depending upon the industry benchmarks.

On a relative basis, EV to EBITDA works best when comparing one company to others in the same industry.

For example, a good comparison would be between AMD and Intel, which largely offer competitive goods, both being chip makers.

Some might say that within the same sector is sufficient, but when you consider the MSCI Global Industry Classification Standard (GICS®), it seems clear this is not usually sufficient. 

The clearest example is the industrial sector, where you might compare a transportation company with a capital goods company. In this case, it is important to understand where and how each company earns its revenue.

Example Of EV/EBITDA

For example, suppose companies in a certain industry trade at 10 times EV to EBITDA on average. In that case, it can be said that a company trading at 15 times EV to EBITDA is overvalued than the historical industry average.

In another manner, if the company has been trading on the public market for 15 times EV to EBITDA on average for a while, but it is now trading at 9 times, a Private Equity firm might see this as an opportunity to take the company private for cheap. Since, the organization can be said as undervalued.

What is EV?

Enterprise value (EV) is an economic measurement used in business valuation. It represents the value of a business to all investors, debt and equity holders. The cash is then subtracted because it could be used to pay off the debt. 

The simplified formula for enterprise value is:

EV = Market Capitalization + Market Value of Debt – Cash and Equivalents

The extended formula is:

EV = Market Value of Common Shares + Market Value of Preferred Shares + Market Value of Debt (long and short-term) + Market Value of Minority Interest + Pension Liabilities Yet to be Funded Along With Other Debt-Deemed Provisions  –  Value of Associate Companies - Cash and Equivalents

The quick and simple idea is that enterprise value is what a potential acquirer would have to pay to acquire the business.

That is to say that the assets are paid for, and debts are paid off. 

As mentioned above, cash is subtracted from the equation. This reduction is usually used in the paying-off the any debt that can be settled with cash.

Limitations Of Enterprise Value (EV)

Enterprise Value (EV) has limitations which include that it does not account for CAPEX, changes in working capital, changes in capital structure, differences in market conditions, market illiquidity, and more.

But, in the context of enterprise multiple, below are some limitations of EV.

1. EV/EBITDA can be distorted by extremely large or small cash stores, especially if compared to a company with significantly different cash reserves.
   • Large cash reserves would effectively lower the EV value and reduce the numerator, thus effectively reducing the EV/EBITDA multiple.
2. The debt may be illiquid on the market. As a result, low trading volumes for a specific company's bonds may need more accurate, up-to-date prices for a company's debt.
3. EV needs to consider the cost of capital. 
   • For example, the cost of capital for issuing each additional dollar of debt demanded by creditors might be cheaper than the cost of issuing an extra dollar of equity required by shareholders.

What is EBITDA?

EBITDA stands for Earnings Before Interest, Taxes, Depreciation, & Amortization. A financial metric used to measure an organization's operating earnings before accounting for non-operating expenses and non-cash items like depreciation and amortization. 

EBITDA is one of the ways to measure a company's profitability. Some financial analysts occasionally favor it as it removes non-operating factors (tax and interest) and subjective factors (depreciation and amortization) from the calculations.

EBITDA provides an unbiased view of the organization's profitability since it eliminates the complexities of non-operating factors, capital structure, and different accounting methods.

Two formulas can help analysts arrive at EBITDA, one is derived from net income, and the other can be derived from operating income. Here are the two formulas respectively:

EBITDA = Net Income + Taxes + Interest Expense + Depreciation & Amortization

EBITDA = Operating Income + Depreciation & Amortization

Limitations Of EBITDA

One of the main criticisms of the EBITDA is that it is a non-GAAP measure. Meaning that companies are not required to report it on their financial statements.

Companies that do opt to report EBITDA are required by the SEC to show how they derived this figure from net income. On the other hand, the SEC prohibits the reporting of EBITDA per share.

As EBITDA is a non-GAAP metric, it may be calculated differently from firm to firm. It's important to keep this in mind, as businesses may try to take advantage and portray good figures. 

Other limitations include

1. Exclusion of Interests and Taxes
2. Exclusion of Depreciation and Amortization
3. Doesn't account for changes in Working Capital
4. Lack of standardization
5. Industry sensitivity

What is the EV/EBITDA Multiple Used For?

EV to EBITDA Multiple is used by analysts to determine if the company is over or undervalued. The metric measures the economic value of the company.

The ratio indicates the amount of times EBITDA should be paid if they were to acquire a corporation.

As mentioned earlier, the lower is typically better. In this light, an investor might see a company's shares trading at 8 times EV to EBITDA in an industry that is 12 on average as a good value. In many cases, this may be true.

So what if the value is extremely low?

This can sound an alarm for some investors. If a company is too undervalued, then

• Prospects do not look good
• Underutilization of financing capacity
• Excess cash, or
• The company is in a dying industry

Negative EBITDA can lead to a negative multiple, just like the price-to-earnings ratio. But with EV to EBITDA, a company with too much cash can also have a negative ratio.

What if the valuation seems high? Usually, this means that the company is just overvalued. However, these companies with stronger growth prospects also tend to attain higher valuations.

Due to financing and liquidity needs, some companies and industries may be higher than the total market average.

Why use EBITDA?

EBITDA is considered to be a performance indicator of the operating performance of the organization. It excludes the interests, taxes, depreciation & amortization from the calculation, which provides a clearer projection of business performance and earnings generation.

Analysts may use EBITDA because it can be used as an approximate proxy for cash flow. This is approximate, as tax and interest are real cash expenses at the end of the day.

Interest can change based on a company's capital structure. The interest can help account for a company's ongoing debt cost, but this does not account for the cost of equity. Removing it from the equation makes sense to avoid letting this skew the company's financials.

The challenge for analysts is that companies may choose to finance more through equity or debt, depending on what fits their needs and is more efficient for the business.

Taxes can change regionally or based on a sector or industry. Making broader comparisons fair would require taking this factor out of the equation. A company in one country or even by state/province may face different taxes than an identical company elsewhere.

However, operating income still considers depreciation and amortization, which can create inconsistencies between companies. Whereas EBITDA eliminates the D&A, streamlining the measurement.

EBITDA can be used in asset-intensive industries. For example, industrials and manufacturing, some consumer staples segments, etc., could all have a hard time finding equal comparisons in their industry unless they all have the same standards for depreciation and amortization.

Using EBITDA to Value a Business

As we mentioned, EBITDA is a rough proxy for cash flow. It also assumes that profitability is a function of revenue and operating efficiency alone, leaving out other key factors that affect the bottom line.

Analysts use it in valuing a business, particularly when considering a buyout of a company.

EBITDA might be more relevant than Net Income because the tax efficiency, debt efficiency, depreciation & amortization rates will all change once acquired.

This further justifies the use of adjusted EBITDA, as some expenses that would be excluded may not concern the acquirer in the long run. 

When it comes to adjusted EBITDA, it seeks to change for extraordinary items not connected to the operating profit of the business, which may include:

• Non-recurring income or expenses
• Non-cash losses
• Legal fees, settlements, and insurance claims
• Other extraordinary items

This process can also be applied when valuing public companies and analyzing EBITDA growth, margin, and the EV / EBITDA multiple.

Researched and authored by Brandon Fausto | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• EV To Revenue Multiple

• Enterprise Value-to-Sales (EV/Sales)

• EV/EBIT Ratio

• Equity Value

• Price Earnings Ratio