EV/EBITDA

EV to EBITDA is a financial multiple, useful to many different investors. For private or public companies in various sectors, this enterprise also applies to multiple companies. Simply, it is the total enterprise value divided by EBITDA.

Some investors use price to earnings as part of their analysis, which relies on the equity value of a business against the trailing twelve months of earnings. 

When you consider all the different ways a company may structure its financing or how a company may choose to depreciate its assets, maybe even the cash reserves a company has, there are plenty of ways the pe ratio falls short.

For one, price is reliant on the equity value of a corporation. However, price only considers the company's equity value and not the value of its debt. Since both equity and debt are put to use in operating the business, it makes sense that investors want a metric that considers this.

Earnings can also vary significantly between companies. How aggressive companies' accounting policies, tax efficiency, and other factors can change the bottom line. So why not compare companies' earnings before these factors?

Enterprise value (EV) to earnings before interest, tax, depreciation, and amortization (EBITDA) allows investors to overcome such concerns.

What is Enterprise Value (EV)?

Enterprise value (EV) is an economic measurement used in business valuation. Its purpose is to combine the value of all claims to the business, creditors, and equity owners, less the cash that would come with the business.

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 new acquirer would have to pay for complete claims on the business. That is to say that the assets are paid for, and debts are paid off. 

Cash is subtracted as there is no purpose in buying cash with cash. In other words, the cash you buy with the business can be paid back to you.

This leads us to the first consideration with EV and our EV to EBITDA formula; it can be distorted by either 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 and, therefore, multiple of an EV/EBITDA multiple. However, value is not necessarily destroyed by having more cash; analysts should remember this.

Another shortfall of using EVs is that 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.

One last shortfall is that EV needs to consider the costs of adding equity or liabilities or keeping less cash. 

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. But EV needs to reveal more about the efficiency of the current capital structure.

What is EBITDA?

EBITDA is one of the few 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.

EBITDA is earnings before interest, taxes, depreciation, and amortization. 

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

However, EBITDA is a non-GAAP measure of profitability, meaning that companies are not required to report their EBITDA on financial statements. That means the above formulas might be worth memorizing for aspiring analysts.

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. Keep this in mind, as businesses may try to take advantage of this and portray good figures. 

Consequently, analysts should be conscious of companies placing too much emphasis on EBITDA or wonder why a company that has never reported EBITDA may choose to start reporting this.

When reporting EBITDA, companies may also opt to post adjusted EBITDA, which is a non-GAAP-recognized metric. Adjusted EBITDA seeks to remove anomalous costs that are either one-time or significantly larger than what is otherwise typical.

Why use EBITDA?

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.

A better explanation is that it can be utilized in understanding the true operating efficiency of a business. However, operating income still considers depreciation and amortization, and we will explain why these metrics can create inconsistencies between companies.

Amortization (for intangible assets) can be excluded as the reduction in the value of intangible assets over time is extremely subjective and can vary widely from business to business. For example, a company may amortize software over what they believe its useful life is.

Depreciation (for tangible assets) can also vary from company to company, depending on which IFRS or GAAP  depreciation method a company chooses, how aggressively it chooses to depreciate an asset, and how conservative the estimated scrap value of the asset is. 

For example, a fleet of delivery trucks might be straight-line depreciated and, after a string of low use, might remain underutilized and cause income to be understated, or vice versa.

Companies would be encouraged to depreciate and amortize more aggressively than necessary to improve tax efficiency and pay less tax, which is a real cash expense for the business.

EBITDA also takes taxes and interest out of the equation.

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 a company's financials.

The problem 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.

Even the price to earnings doesn't account for the required rate of return on equity, so taking out interest expense (cost of debt) logically makes sense. 

Taxes can change based on region and sector or even 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.

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.

How is EBITDA used?

As we mentioned, EBITDA is a rough proxy for cash flow. EBITDA 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 EBITDA in valuing a business. Particularly when considering a buyout of the 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, analyzing EBITDA growth, margin, and why you are here EV / EBITDA.

What is EV/EBITDA?

EV to EBITDA is an enterprise multiple used for the valuation of a company. For example, it can be used to understand the total cost of buying out a company (debt and equity claims) against the operating profits, less non-cash expenses.

The formula is easy to remember as it is in the name:

EV to EBITDA = EV / EBITDA

As with other valuation metrics, the first thing to understand is what a "high" or "low" valuation might be. It has been said that below ten is considered healthy, but broadly speaking, some indices have averaged above that, bringing us to the first point of using EV to EBITDA.

EV to EBITDA should be used both on a relative and a historical basis. 

For example, suppose companies in an analyst's industry trade at 10 times EV to EBITDA. In that case, they might say that a company trading at 15 times EV to EBITDA has a higher valuation 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 PE firm might see this as an opportunity to take the company private for cheap.

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 each company earns its revenue.

Using EV to EBITDA

So, as mentioned, 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, it might be that its prospects do not look good, they are underutilizing its financing capacity, or there is too much cash.

As you may have guessed, 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? Well, regularly, this might mean that the company is 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.

Researched and authored by Brandon Fausto | LinkedIn

Free Resources

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