Introduction to EV/EBITDA

Introduction

EV (Enterprise Value) to EBITDA (Earnings before Interest, Taxation, Depreciation and Amortization) is one of the most commonly used metrics in valuation and is seen as an alternative to the famous P/E (Price to Earnings) ratio. Analysts and investors indeed might see EV/EBITDA as a more reliable and comprehensive way to compare companies in a specific industry than the simple P/E ratio.

Its purpose is to work out whether a stock is cheap or expensive. Hence the ratio has multiple uses such as to calculate a target price for a company in an equity research report, in negotiations for the acquisition of a business, to compare the valuations of multiple companies and to determine what multiple a company is currently trading at in order to know whether their stock is cheap or not.

Let’s take a closer look at the two components of the ratio: The Enterprise Value and the Earnings before Interests, Taxation, Depreciation and Amortization. We will also see how good an alternative to the P/E ratio EV/EBITDA is, as well as its limits.

What is EV?

The Enterprise Value is a way of capturing the value of a company and is widely used as a theoretical takeover price if a company were to be bought. Instead of adding up one by one the value of every assets of a company, which is the purchase price of all assets (market value), the EV ratio looks at how those assets have been paid for. Thus, it says that we can value a company by looking at how it has been paid for in terms of its assets, rather than necessarily going through them one by one.

The two main sources of funding of a company are the shareholders or banks, and that explains the formula of the EV ratio:

EV= Market Capitalization + Debt - Cash

The Enterprise Value starts with the Market Capitalization, which is the number of shares in issue times the current share price and that tells the value of the equity contribution from shareholders. Following this, we want to add on to that the contribution of banks and lenders, known as Net Debt. It is calculated by subtracting a company’s total cash and cash equivalents from its total short-term and long-term debt. But why should we deduct the cash of a company whilst evaluating it? Simply because when acquiring another company, a firm pays the value of the target firm’s debt but keeps its cash, which is why cash needs to be deducted from the firm’s price (Market Cap).

Let’s take an example. A company has issued 300,000 shares that are currently value at a market price of $10.00 a share and borrowed $1,000,000 from a bank. If the firm has cash worth of $250,000 then its Enterprise Value can be calculated as follow:

EV= 300,000*10.00 + 1,000,000 – 250,000

EV= $3,750,000

Therefore, the firm could potentially be acquired for this amount of money.

What is EBITDA?

Let’s break down what EBITDA is: why is it considered to be useful and where it comes from?

EBITDA appears in many analysts reports and investors use it to analyse and compare profitability between companies and industries. It allows also to evaluate firms with different tax rates and depreciation policies.

EBITDA is a variation of a standard operating profit number and to create this number we start by the operating profit number of a company, also known as Earnings before Interest and Tax (EBIT). Then we add back the depreciation expense and we also add back the annual amortisation charge, hence E.B.I.T.D.A. Depreciation and amortization are measures of that portion of the cost (or fair value) of a non-current asset that has been consumed during a reporting period. The word ‘amortization’ tends to be used where the particular non-current asset is an intangible one (i.e., a patent, trademark), whereas ‘depreciation’ is normally used with tangible assets (i.e., inventory, land, equipment).

However, we need to be aware that directors who calculate these figures tend to make subjective assumptions including how long will the asset last (useful economic life), what it will be worth when they finish with it (residual value) and even what method they are going to use to actually depreciate the asset over its useful economic life.

The first method is called straight-line and the asset is depreciated by a constant charge over the years, and the second method is known as ‘reducing-balance’ and applies a percentage to the book value of the asset. The latter means more depreciation in the early years and less in the later years of the useful life of the asset.

The full formula for EBITDA is the following:

EBITDA = Net Profit + Interest + Taxes + Depreciation + Amortization

Let’s take an example of an income statement and see how to calculate it from the numerous figures in this financial statement:

From this example, we take the net profit and add back the interest, tax, depreciation and amortization to find our EBITDA.

EBITDA = 23 + 50 + 32 + 20 + 25

EBITDA = £150m

After finding this number, it is usual to compare it to other companies to see how healthy and profitable our company is in its industry.

Why should you use EV/EBITDA over the P/E ratio?

Now that we have just seen how to calculate the EV/EBITDA ratio, we can ask ourselves: What’s the point of it? Why would we want to do this ratio at all? Because if we want to work out if a share is cheap or expensive, don’t we use the famous P/E ratio for example?

The Price to Earnings ratio (P/E) is way more popular and is relatively easy to find or calculate. It is just the contributions of shareholders (market capitalization) as a multiple of one’s year profit after tax. Nonetheless, fans of the EV/EBITDA ratio say that there are two problems regarding the components of the P/E ratio.

1. The contribution of shareholders to company, ‘P’, is not comprehensive enough. What about banks and lenders? Where are their contribution shown? If the market cap supposed to be the total valuation of a company, isn’t there something missing?

2. The ‘E’ or profit after tax: is that really a representative earnings figure for a company? E is indeed stated after lots of costs that have nothing to with the operating business of a company.

3. Many of these costs are subjective as we saw previously, such as depreciation and amortization or even tax, which are subjects to specific rules. Advocates of EBITDA declare that we should replace the market cap of the P/E ratio by something more comprehensive, the enterprise value. We also want to replace the profits after tax with something which is closer to a more reliable figure for earnings: Earnings before Tax, Interest, Depreciation and Amortization.

From the P/E ratio, we can add up these figures to have our EV/EBITDA:

Limits of EV/EBITDA

We should not forget that there are opposing views for this ratio: it is a contentious ratio even though it is quite widely used. For instance, one of the protestors of this ratio is Berkshire Hathaway’s Charlie Munger who declared that he translates this ratio as “bulls**t earnings”. Some, including Munger, say that EV/EBITDA is not a true reflection of a company’s performance. In many situations, a firm’s biggest expenses are taxes, interests and depreciation and therefore EV/EBITDA could hide these major expenses. Consequently, it may produce a more favourable multiple by not including those expenditures.

Conclusion

The EV/EBITDA multiple is one of the most commonly used financial valuation ratio that measures a company’s profitability. EV/EBITDA is seen as a more comprehensive and reliable way to compare companies in a particular industry than the P/E ratio. It gets rid of subjective expenses such as depreciation/amortisation as well as expenses that have nothing to do with the profitability of a business (tax and interests). Therefore, it allows investors and analysts to create more precise comparisons of companies with different capital structure.

The interpretation of this ratio is pretty similar to the P/E ratio: a low EV/EBITDA tends to mean that a stock is not well rated or cheap, depending on your perspective, and a high one means that it is highly rated or expensive. To get a real feel to see whether the stock is cheap, you would want to compare it with other companies from the same industry. Analysts and investors commonly interpret an EV/EBITDA as healthy when it is valued below 10x. Finally, EV/EBITDA should be analysed with a pinch of salt as depreciation, tax, interests and amortisation can be a huge part of a company’s total expenses.

APPENDIX

To support our introduction to EV/EBITDA, let’s take a look at this ratio of companies such as Facebook, Google and Apple in their growth year.