Ashutosh Garg, Product Manager, Refrens.com
EV/EBITDA is a ratio that compares a firm’s enterprise value (EV) to its earnings before interests, taxes, depreciation, and amortization (EBITDA). EV/EBITDA is a common valuation metric that is used to compare the valuation of different businesses. EV/EBITDA is also known as Enterprise Multiple.
What is EV?
EV, or enterprise value, is the numerator in the EV/EBITDA ratio. By definition, EV means a firm’s market capitalization plus its debt less of any cash with the company. Debt minus cash can be understood as net debt.
So, EV = Market Capitalization + Net debt
where Net Debt = Total Debt - Cash
What is EBITDA?
EBITDA means earnings before interests, taxes, depreciation, and amortization. When it comes to valuation, EBITDA is often considered a proxy of cash flow. In simple terms, EBITDA can be understood as earnings (revenues minus all other expenses) before deducting any of the interest, taxes, depreciation, and amortization.
Earnings (Revenue - Costs) - (Interests + Taxes + Depreciation + Amortization)
What does EV/EBITDA imply?
EV/EBITDA is used to compare the entire value of the business with respect to its EBITDA, on an annual basis. EV/EBITDA as a ratio shows how many times EBITDA one has to pay to acquire the entire business.
Usage of enterprise multiple
Enterprise multiple is generally used to determine whether a company is overvalued or undervalued. A lower enterprise multiple would mean the company is undervalued. Similarly, higher enterprise multiple values would mean the company is overvalued.
EV/EBITDA finds its application in analyzing multinational companies. This is because it considers everything regardless of tax, the local taxation rules do not play a significant role in deciding the valuation.
EV/EBITDA as a ratio is also used to evaluate merger candidates. A company with low enterprise multiple is a good candidate for takeover.
Some other notable uses of EV/EBITDA include:
- Determining the current multiple of trading
- Finding the target prices of a company in equity reports
- Comparing the valuation of multiple companies
- Calculating the terminal value in discounted cash flow
Pros and cons of EV/EBITDA
- Can be calculated with publicly available information
- Good for businesses with low capital expenditures.
- Has found wide usage in the Financial community
- Disregards effects of non-cash expenses
- Does not give an accurate picture of cash flow
- Capital expenditures are not taken into account. Capital expenditures might be very significant and ignoring them might not be right in case they are high
- Growth rates cannot be explained through enterprise multiple
- Market cap (derived from historic stock values) might not be a good predictor of future growth
Overall, EV/EBITDA is a good indicator of the company’s value. In fact, it is better than a host of other multiples like price to earnings ratio, etc. because it is not affected by the company’s capital structure. This makes the enterprise multiple an ideal to compare companies of different structures.
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