What is EV/EBITDA? How to Use it?

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April 9, 2022

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Introduction

The EV/EBITDA ratio, or Enterprise Value to Earnings Before Interest, Tax, Depreciation, and Amortisation, is one of the most well-known ratios employed by value investors. The enterprise multiple, or EV/EBITDA multiple, is another name for it. 

The EV/EBITDA multiple is calculated by professional investors utilising data from a company’s financial statements and balance sheet. As a general rule, a firm with a high EV/EBITDA ratio may be overvalued at its prevailing stock price. A firm with a low EV/EBITDA ratio, on the other hand, may have a share price that is too low and would provide more relative value to an investor.

What is EV?

Enterprise value is represented as EV. The following formula can be used to compute it: 

Market Capitalization + Debt + Minority Interest + Preference Interest Expenses – All Cash and Cash Equivalents Enterprise Value = Market Capitalization + Debt + Minority Interest + Preference Interest Expenses 

The following are the elements of a company’s enterprise value: 

Market value (or market cap) is calculated by multiplying the company’s share price by the number of shares outstanding. 

Debt: This term refers to both short- and long-term debts owed to lenders. 

Minority interest: The total value of shares held by minority shareholders is referred to as minority interest.

Preferred interest: Preferred stockholders receive preferred interest. A preference share entitles its bearer to a fixed payout regardless of the company’s profitability. 

Cash: Cash and cash equivalents are the liquid assets that a company has on hand.

The computed enterprise value can theoretically be thought of as the price or value at which a firm would be purchased by an investor. In this instance, the buyer will have to assume responsibility for the organisation’s debt as well. 

The addition of debt offers the enterprise value a distinct benefit in terms of representing the value of a firm. It’s because, in any takeover situation, the debt must be taken into consideration.

What is EBITDA?

EBITDA is an acronym for Earnings Before Interest, Tax, Depreciation, and Amortisation. EBITDA, or earnings before interest, taxes, depreciation, and amortisation, is a metric that is used to assess a company’s financial performance. We can use this to determine the earnings potential of a certain company’s operations. 

In simple words, the formula for EBITDA is as follows: 

Operating Profit + Depreciation + Amortisation = EBITDA 

The operating profit is calculated by adding the net profit, interest, and taxes. Depreciation and amortisation expenses play a crucial part in calculating EBITDA. So, in order to fully comprehend the phrase EBITDA, these two words are briefly defined below:

Depreciation is a method of allocating the cost of a tangible item over its useful life in accounting. For tax and accounting purposes, businesses depreciate their long-term assets. Businesses can deduct the cost of tangible assets they purchase as a business expense for tax purposes.

Amortisation: Amortisation is the process of paying off debt over a certain period of time with a set repayment schedule and regular instalments. A mortgage and an auto loan are two common instances of this. It also refers to the amortisation of capital expenses for intangible assets over a specific time period, for accounting and tax purposes. 

EBITDA is net income after interest, taxes, depreciation, and amortisation have been deducted. Because it eliminates the effects of financing and accounting decisions, EBITDA may be used to examine and compare the profitability of different businesses and industries. This value is particularly valuable since it removes unnecessary elements like interest, tax, depreciation, and amortisation, giving a raw and straightforward value of earnings. Private equity investors became interested in EBITDA because it could be used to determine whether a company could pay its loans in the near future.

Interpreting EV/EBITDA

The payback period is one method of interpreting the ratio. If the multiple is 5, for example, it will take 5 years to recoup the cost of acquiring the company using EBITDA. 

A greater EV/EBITDA ratio than peers, the industry average, or the historical average indicates a higher value for the company. If, on the other hand, this multiple is lower than peers, the industry average, or the historical norm, the firm is undervalued. 

As a result, the reduced EV/EBITDA multiple makes the company more appealing for investment. Because it appears to be discounted, the buyer can continue to benefit until the market recognizes the same and valuation returns to industry typical levels.

Where to use EV/EBITDA?

Best for International Comparison. 

The EV to EBITDA multiple is useful for comparing two companies across countries since it takes into account the influence of taxation rules on earnings. Because each country’s tax structure is unique, this multiple entirely overcomes any taxation limitations and valuation distortions.

Mergers and Acquisitions are the most common applications. 

The EV/EBITDA multiple is a great indicator for valuing a company, and it’s especially useful for mergers and acquisitions, division splits, and sales. Because market capitalization is deceptive because it ignores the impact of indebtedness, it is not a reliable indicator. 

Suitable for Businesses with a High Capital Expenditure 

The enterprise multiple is best suited to capital-intensive industries with significant depreciation and amortisation costs. As a result, these non-cash charges have a negative impact on operating results.

EV/EBITDA as an alternative to the P/E ratio 

The P/E ratio is a measure of how much the market is ready to pay for a stock for each rupee it earns. The P/E ratio is the input that influences the stock price. The payback period is measured by the EV/EBITDA ratio. It is the time it takes for your investment in a company to be repaid in the form of EBITDA generated by the company.

The P/E ratio is a useful indicator of a company’s equity worth. It provides a more accurate picture of equity valuation because it uses the residual profit (EPS) as the denominator. When it comes to mergers and acquisitions, the EV/EBITDA ratio is a stronger indicator of firm value. EV/EBITDA gives a more complete picture of the company, accounting for both stock and debt in the capital structure. 

Manufacturing enterprises and corporations with a well-developed business plan benefit from the P/E ratio. In the case of service organisations with a long gestation period, EV/EBITDA works better. For example, capital-intensive industries like telecommunications and emerging industries like Fintech and eCommerce can benefit from using EV/EBITDA as a valuation metric.

Regardless, many investors prefer PE to Enterprise multiple because determining the market value of debt can be tricky at times. The PE ratio is simple to calculate.

Conclusion

Even though the EV/EBITDA multiple has its drawbacks, it is still the best multiple for valuation. It is common and serves as a point of reference for determining if the price put on the market is acceptable or not. During the mergers and acquisitions process, it gives both parties a fair picture. Better results can be obtained by combining the Enterprise multiple with other valuation multiples such as the PB ratio and the PE ratio. As a result, rather than using this multiple alone to compare across industries and scales, it is advisable to combine it with other complementing multiples.

Very important note: The objective of this blog is to share knowledge and info about multibagger ideas/opportunities. Neither is this trading website nor an analyst website nor a Buy/Sell call website. For stock market success, always do your homework, own analysis, and make your own decisions.

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The author of the blog Mr.Suyog Dhavan is a Full-time Investor / Value Trader and Value investing/Trading Mentor. His style of Investing is inspired by Mohnish Pabrai, Peter Lynch, and Porinju Veliath. He is the founder of Strategic Alpha Wealth, A Premier stock market mentorship firm with a mission to touch the lives of 1Lakh people through its mentorship program.

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