Everything You Need To Know About EV/EBITDA

July 27, 2023
10 MIN READ
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Industry-specific enterprise value (EV) to earnings before interest, taxes, depreciation, and amortization (EBITDA) ratios exist. Nevertheless, during the previous six years, the S& P 500's EV/EBITDA ratio has consistently been between 11 and 16. EBITDA assesses a company's entire financial performance, whereas EV defines the whole worth of the company. The mean score EV/EBITDA for the S& P 500 in December 2021 was 17.12. Investors and analysts usually consider an EV/EBITDA number of less than ten as good and above average.

What is EV/EBITDA?

The enterprise multiple, the EV multiple, is a ratio employed to evaluate a company's worth. The enterprise multiple, calculated as enterprise value divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), examines a firm in the same manner that a potential acquirer would, taking debt into account. What constitutes an "acceptable" or "negative" business multiple varies by industry. 

Enterprise Multiple Formula and Calculation

The formula of enterprise multiple

Enterprise Multiple = EV / EBITDA

where:

EV (Enterprise Value) = Market capitalization + total debt − cash and cash equivalents

Calculation of enterprise multiple

Compute the organization's market value by multiplying the current shares by the present market price of one stock. Add the entire long-term and short-term debt of the firm to this figure. Finally, deduct the cash and its equivalents of the firm. This now computes the enterprise value of the firm.

This outcome indicates the amount of money required to purchase an entire firm. The enterprise value is the imaginary takeover price one firm must pay to gain another. While other criteria may influence the ultimate purchase price, enterprise value provides a complete option for determining a business's value than the value of markets alone.

Enterprise value

Enterprise value (EV) is a complete estimate of an organization's entire value than market capitalization. EV considers not only a business's value but also its short- and long-term debt, as well as any cash or cash equivalents on its balance sheet.

Another factor to consider is that an organization's EV might be negative if the total value of its monetary assets exceeds the whole value of its market cap and obligations. This indicates that a corporation is not making the most use of its assets—it has excess cash hanging around doing nothing. Extra income can be utilized for various purposes, including dividends, buybacks, growth, servicing, employee pay hikes, research & development, bonuses, and debt repayment.

Many financial measures that gauge the achievement of an organization are based on enterprise value. The enterprise multiple, for instance, includes enterprise value. It connects a company's entire value from all sources to a measure of operating earnings: earnings before interest, taxes, depreciation, and amortization (EBITDA).

Elements of enterprise value (EV) 

Enterprise value is calculated using information from financial filings and current market pricing. EV is made up of the following components:

·       Market cap: The entire value of a firm's outstanding ordinary and preferred stock.

·       Debt represents the total amount of long-term and short-term debt.

·       Unfunded pension obligations (if any) represent the capital required to support pension payouts or the amount a corporation must set aside to create pension payments under an unfunded plan. If this figure exists, the market cap can be added.

·       A minority stake represents the equity worth of a subsidiary that owns less than 50% of the company. It may be added to the market cap to calculate the EV.

·       A minority stake is the equity worth of a subsidiary that owns less than 50% of the company. It may be added to the market cap to calculate the EV.

·       Money and its equivalents indicate a corporation's total cash, money orders, business paper, convertible bonds, certificates of deposit, money market funds, short-term sovereign bonds, drafts, or Treasury bills.

EBITDA

EBITDA is a valuable stakeholder metric to assess an enterprise's overall financial earnings and efficiency. EBITDA is a simple indicator that shareholders may compute using figures from an enterprise's balance sheet and income statement. EBITDA allows traders to compare a firm to industry averages and other companies.

Calculation of EBITDA

To estimate EBITDA for a corporation, first locate the profits, tax, and interest amounts on the income statement. The depreciation and amortization numbers may be seen in the cash flow statement of the organization. To calculate EBITDA, however, a handy shortcut is to start with the company's operational profit, also known as earnings before interest and taxes (EBIT). Depreciation and amortization can then be added back in.

The concept of enterprise multiple

Investors mostly analyze the enterprise multiple of a firm to assess whether it is cheap or overpriced. A low ratio compared to peers or past trends suggests that a firm is undervalued, whereas a high ratio suggests that the company is overpriced.

Since it avoids the distorting effects of various nations' taxation systems, an enterprise multiple is beneficial for transnational comparisons. It is also used to locate suitable takeover prospects since enterprise value incorporates debt and is a better statistic for merger and acquisition (M&A) reasons than market capitalization.

Depending on the industry, enterprise multiples might vary. It is realistic to predict greater enterprise multiples in high-growth businesses (such as biotech) and lower multiples in slow-growth industries (such as railways).

EV is an indicator of an organization's economic worth. It is routinely used to assess the worth of a firm if it is bought. It is considered a superior valuation metric for M&A than a market cap since it covers the debt a purchaser would have to absorb and the cash they would get.

Applications of enterprise multiple

The most typical applications of EV/EBITDA are:

·       To find out what multiple a firm is now trading at (for example, 8x),

·       To compare several company valuations 

·       In a Discounted Cash Flow DCF model, the terminal value is calculated.

·       When negotiating the acquisition of a private company

·       In an equity research study, a target price for a firm is calculated.

Effects of enterprise analysis

The lower the EV/EBITDA ratio, akin to the P/E ratio (price-to-earnings), the lower the firm's price. Even though the P/E ratio is often employed as the primary valuation tool, it has advantages in conjunction with the EV/EBITDA. For instance, most traders want firms with low P/E and EV/EBITDA prices and robust dividend growth.

The benefits and drawbacks of EV/EBITDA

There are several advantages and disadvantages to employing this ratio. As with other things, whether it is deemed a "good" statistic depends on the context.

Among the benefits are:

i.     Simple to compute using publicly available data

ii.    Widely utilized and cited in the financial sector.

iii.    Effective for evaluating solid, established enterprises with modest capital outlays.

iv.    Excellent for comparing the relative worth of several businesses.

Drawbacks include the following:

i.     This is not a suitable proxy for cash flow.

ii.    It does not account for capital expenses

iii.   It isn't easy to account for varying rates of growth.

iv.   It is difficult to justify observed "premiums" and "discounts" (which are primarily subjective).

The risks of using enterprise multiple

An enterprise multiple is a statistic used to identify desirable acquisition opportunities. However, be wary of value traps, stocks with low multiples because they are merited (for example, the firm is suffering and will not recover). The appearance of a value investment is created, yet the basic principles of the sector or firm indicate negative returns.

Investors believe a stock's historical performance predicts future returns; thus, when the multiple falls, they typically seize the opportunity to purchase it at a "low" price. Comprehension of the industry and business fundamentals can aid in determining the stock's true worth.

One simple approach to accomplish this is to examine predicted (future) profitability and see if the predictions satisfy the criteria. Forward multiples must be less than TTM multiples. Value traps arise when these future multiples appear to be excessively low, but the fact is that the expected EBITDA is too elevated. The price of the shares has already declined, possibly reflecting the market's caution. As a result, it is critical to understand the triggers for the firm and industry.

Which corporations can be best assessed using EV/EBITDA?

The cable and telecom business is the logical choice, given it is where the metric arose in the first place. Telecom is an ideal use case since the companies involved are among the most strained worldwide, investing tens of billions of dollars to create while sustaining their connections. Large sums of depreciation and amortization also accompany that spending.

Using EV/EBITDA to contrast telecom corporations provides traders with a comparative study across different sector players despite radically different financial obligations, fixed investments, and interest expenditures.

The same concepts in telecommunications also apply to many other businesses with a major fixed asset element. Airlines, truckers, and railways are frequently studied using EV/EBITDA since such organizations spend extensively on the vehicles that power their activities and frequently have huge levels of debt or finance to support their operations.

EV/EBITDA is especially frequent in the basic materials and industrial industries, where firms must spend extensively on mining operations, oil fields, chemical plants, and industries, among other things. These are sunk expenses since the money to create one of these facilities has already been invested. The depreciation of these fixed assets can have a significant impact on profitability. Nevertheless, EV/EBITDA might be a far more helpful statistic than accounting earnings for traders interested in the financial return that such existing resources may offer.

What firms should not be valued using EV/EBITDA?

When using EBITDA to examine firms where capital investments are a big and regular expense that cannot be interrupted, investors might get into problems.

Depreciation, for instance, is a massively substantial expenditure for a cruise line operator. An ancient cruise ship will no longer be capable of luring clients, and its navigability may be questioned at a given time. A shareholder should not simply write off depreciation as a non-cash expenditure; the firm may cease to exist if a novel cruise ship is not acquired promptly.

There are numerous businesses where depreciation is more than just a financial factor; it is an extremely prevalent expenditure with significant effects if disregarded for an extended period.

In certain circumstances, depreciation is a non-monetary expenditure that is not always recurrent. Consider real estate, where the monetary worth of a building is sometimes written down dramatically due to aging, even while the underlying land and architecture might retain and possibly improve in value. However, in extremely costly businesses where equipment wears out fast, one should exercise extreme caution before relying completely on an EBITDA value ratio instead of revenues.

A different problem might occur with businesses that include a financial component. As previously stated, financial institutions should not be evaluated using EBITDA or EV/EBITDA since interest expenditure would distort the underlying profitability profile. In recruiting deposits to support the bank, settling interest is critical to their business plan. Some FinTech firms recently provided adjusted EBITDA numbers to stockholders instead of earnings. This raised suspicion because, as part of their business strategy, these businesses frequently paid substantial sums of interest to draw in cash to support their core activities. In such a circumstance, omitting interest from profitability computations may seem counterintuitive.

EV/EBITDA vs. P/E Ratio

The P/E ratio has become a primary market assessment tool, and the immense amount of historical and present-day information lends weight to the statistic in stock research. Some experts believe employing the EV/EBITDA ratio as a valuation approach rather than the P/E ratio delivers superior investment returns.

Both measurements have advantages and downsides inherent in them. As with any financial statistic, numerous financial ratios, such as the P/E ratio and the EV/EBITDA ratio, must be considered when deciding if a firm is reasonably priced, overpriced, or underpriced.

Conclusion

The EV/EBITDA ratio is a valuable measure. Nonetheless, it is only one mechanism in a financial system, and it has grown in popularity recently. As a result, some experts have expanded its applications beyond its intended purpose. EBITDA arose to contemplate leverage on top of assets with long lifespans like cable television networks. It can provide a rapid gauge of cash flow creation among enterprises within a sector. Still, traders should avoid generalizing EV/EBITDA ratios due to inherent limitations.