What is EV to EBIT Ratio?
EV to EBIT is a one of the important valuation tools and is calculated as the ratio between enterprise value, which encompasses the total company’s value instead of just the market capitalization and earnings before income taxes, which gives information about how much business a company has successfully done over a certain period.
Let us look at Facebook vs. General Motors Valuations from the above graph. Facebook is trading at EV to EBIT of 24.21x; however, General Motors multiple is around 9.16x. Does this mean that General Motors is trading cheap, and we should buy General Motors as compared to Facebook?
I think the answer lies in understanding what EV to EBIT is all about. In this article, we look at EV to EBIT in detail –
- What is Enterprise Value?
- What is EBIT?
- Formula and Interpretation
- Calculation – Amazon
- Forward vs. Trailing
- Services Sector?
- Oil & Gas Sector?
What is Enterprise Value?
Enterprise Value is the total value of the firm. Enterprise value depicts the value to the overall stakeholders, including the debt holders, shareholders, minority shareholders as well as preference shareholders.
The formula for Enterprise value is as follows.
EV = Market Cap + Debt + Minority Interest + Preference Shares – Cash & Cash Equivalents.
Enterprise value can be considered as the total consideration at which the company can be bought by the investor. This implies that the buyer will also assume the debt of the company, which he will have to pay off.
For a detailed note on Enterprise Value, please refer to Enterprise ValueEnterprise ValueEnterprise Value is a measure of a company's total value that spans the entire market rather than just the equity value. It includes all debt and equity-based ownership claims. This value, which is calculated as the market value of debt + market value of equity - cash and cash equivalents, is particularly relevant when valuing a takeover. Guide.
What is EBIT?
Let us have a look at the Income Statement of Colgate above. Is the Operating profit in Colgate, EBIT (Earnings Before Interest and TaxesEarnings Before Interest And TaxesEarnings before interest and tax (EBIT) refers to the company's operating profit that is acquired after deducting all the expenses except the interest and tax expenses from the revenue. It denotes the organization's profit from business operations while excluding all taxes and costs of capital.), or EBITDA (Earnings Before Interest Taxes Depreciation & Amortization)?
source: Colgate SEC Filings
The above Operating Profit of Colgate is EBIT. EBIT is defined as any company’s profit, including all expenditures just leaving income tax and interest expenditures. However, EBITDA measure is good to be used for analyzing and comparing profitability between firms and businesses as it removes the impacts of accounting and financing decisions.
Please have a look at this guide for detailed differences between EBIT vs. EBITDA GuideEBIT Vs. EBITDA GuideEBIT signifies the operating profit the company makes before the inclusion of interest and tax expenses. In comparison, EBITDA determines the company's overall operational profitability by summing the depreciation and amortization expenses to the operating profit..
EV to EBIT Formula and Interpretation
EV/EBIT multiple gives the answer to the query “What is the company’s valuation worth per Operating Profit dollar”.
EV to EBIT formula = Enterprise Value / EBIT =
EV / EBIT = (Market Capitalization + Debt + Minority InterestMinority InterestMinority interest is the investors' stakeholding that is less than 50% of the existing shares or the voting rights in the company. The minority shareholders do not have control over the company through their voting rights, thereby having a meagre role in the corporate decision-making. + Preference Shares – Cash & Cash Equivalents)/EBIT
- The above formula in detail measures if a company’s share is expensive or cheap as compared to the broader market or competing firm.
- This ratio is an improved version of the traditional P/E multiple that overcomes the limitations of PE ratioPE RatioThe price to earnings (PE) ratio measures the relative value of the corporate stocks, i.e., whether it is undervalued or overvalued. It is calculated as the proportion of the current price per share to the earnings per share. as it also has taken a balance sheet into consideration. Therefore, rather than just using the company’s share price, the company employs enterprise value that also includes debt.
- PE ratio is the most commonly used and easiest valuation technique to measure any company’s capability to deliver profits compared to the market. This multiple is occasionally used as against the P/E multiple to relate profit expansion among companies in industries having huge quantities of debt like high capital intensiveCapital IntensiveCapital intensive refers to those industries or companies that require significant upfront capital investments in machinery, plant & equipment to produce goods or services in high volumes and maintain higher levels of profit margins and return on investments. Examples include oil & gas, automobiles, real estate, metals & mining. businesses.
- A large or small multiple signifies that the firm is expected to be either overvalued or undervalued. EV/EBIT is most often studied by the key analysts to promptly identify the firm’s trading valuation multiples. Keeping all other things unchanged, the smaller this ratio comes out to be, the healthier.
- Investors are advised to go through any company’s EV to EBIT ratio and make it a core tool to identify the company’s earnings capabilities while also comparing it with other companies as well to get a clearer insight into which stock is best for investments at that point of time, in the short-term or over the longer term. Further, this ratio is generally believed to be used by Buffet and Greenblatt for determining any business’s health.
EV to EBIT Calculation – Amazon
Calculation of Enterprise Value = (Market Cap + Debt + Minority Interest + Preference Shares – Cash & Cash Equivalents)/EBIT
Market Capitalization = Number of Shares Outstanding x Current Price.
source: Amazon SEC filings
Amazon Share Price (as of 2/21/2017 closing) = 856.44
Number of outstanding sharesNumber Of Outstanding SharesOutstanding shares are the stocks available with the company's shareholders at a given point of time after excluding the shares that the entity had repurchased. It is shown as a part of the owner's equity in the liability side of the company's balance sheet. (as of last reported 10K) = 477 million
Amazon Market Capitalization = 856.44 x 477 = 408,522 million
- There are no Preferred Shares in Amazon
- There is no component of Minority Interest
- Amazon’s cash and cash equivalents are $19,334 million.
source: Amazon SEC filings
Amazon’s has a very small amount of debt in its balance sheetIts Balance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company..
source: Amazon SEC filings
Amazon’s Enterprise value = Market Cap + Debt + Minority Interest + Preference Shares – Cash & Cash Equivalents
Amazon’s Enterprise value = 408,522 million + 7,694 + 0 + 0 – 19,334 = $396,882 million ~ $396.88 billion
source: Amazon SEC filings
Amazon’s EBIT of 2016 is $4,186 million.
Amazon’s EV to EBIT = $396,882/ $4,186 = 94.81x
EV to EBIT – Forward vs Trailing
This multiple can be further subdivided into Investment BankingInvestment BankingInvestment banking is a specialized banking stream that facilitates the business entities, government and other organizations in generating capital through debts and equity, reorganization, mergers and acquisition, etc. Analysis.
- Trailing Multiple
- Forward Multiple
Trailing Multiple (TTM or Trailing Twelve Months) = Enterprise Value / EBIT over the previous 12 months.
Likewise, the Forward Multiple = Enterprise Value / EBIT over the next 12 months.
The key difference here is the EBIT (denominator). We use the historical EBIT in trailing multiple and use forward or EBIT forecast in the forward multiple.
Let us look at the example below to understand how they are used.
There are six companies A, B, C, D, E, and F.
You are provided with Current Price, Enterprise value, EBIT, and EV to EBIT forecasts of all six companies. You need to find the following –
- Which company will you invest in?
- Which company is the worst from the valuation point of view?
Which company should you invest in?
The answer to this question lies in the knowledge of trailing and forward multiple.
Take a look at the table above, you will note that EV to EBIT is lowest for company B in 2016A at 26.7x, while it is highest for Company D at 80.0x. This makes us believe that Company B is the cheapest. However, this is an incorrect conclusion! You should never value a firm on the basis of what has already happened in the past. Instead, you should give more weight to the future of the company, and therefore forward EV/EBIT becomes critical. If you take forward EV to EBIT of Company B, you will note that it has increased dramatically to 40.0x in 2018. On the other hand, the lowest forward multiple is that of Company D. This is the one you should look at from the investment point of view.
Which company is the worst from the valuation point of view?
Again the answer to this question lies in analyzing the estimated EV to EBIT. We note that even though Company B had the cheapest multiple in 2016 (at 26.7x), however, its EV to EBIT continuously increased to 33.3x and 40.0x in 2017 and 2018, respectively. This happened due to a decrease in EBIT in 2017 and 2018.
Also, note that even though Company C has a higher multiple (48.6x) than that of Company B (40.0x), going by the trend, it seems like Company B is going to be worse off in 2019E.
Can I use EV to EBIT in the Services Sector?
Services companies do not have a large asset base; their business model is dependent on Human Capital (employees). Due to this depreciation and amortization in Servies Companies in generally non-meaningful.
The difference between EBIT margin and EBITDA marginEBITDA MarginEBITDA Margin is an operating profitability ratio that helps all stakeholders of the company get a clear picture of the company's operating profitability and cash flow position. It is calculated by dividing the company's earnings before interest, taxes, depreciation, and amortization (EBITDA) by its net revenue. EBITDA Margin = EBITDA / Net Sales can tell us the relative amount of depreciation and amortization in the Income Statement. We note from the graph below that the difference between EBIT Margin and EBITDA Margin for Infosys is approximately 1.24% (27.34% – 26.10%). This is expected from a services firm as they operate as an Asset Light model.
Since the difference between EBIT and EBITDA is not much, you can easily use EV/EBIT or EV/EBITDA for Software companies valuations.
Other services sector where you can apply EV to EBIT are –
- Internet Tech & Content
- Software Applications
- Advertising Agencies
- Marketing Services
Can I use EV to EBIT in the Oil & Gas Sector?
Oil & Gas companies are Capital Intensive companies that invest heavily in plants and manufacturing setup and are dependent on continuous investments in assets to manufacture finished products. Therefore, with a higher asset base, its depreciation and amortization are relatively higher.
Now let us compare the above graph with that Exxon. Exxon is an Oil & Gas company (highly capital intensive firm). As expected, we note that the difference between EBIT Margin and EBITDA margin is very high – approximately 8.42% (13.00% – 4.58%). This is because of heavy investments in Plant Property and EquipmentPlant Property And EquipmentProperty plant and equipment (PP&E) refers to the fixed tangible assets used in business operations by the company for an extended period or many years. Such non-current assets are not purchased frequently, neither these are readily convertible into cash. that leads to high depreciation and amortization figures.
Using this multiple in Oil & Gas sectors will be incorrect due to the presence of higher depreciation and amortization. Higher depreciation and amortization can lead to very low EBIT values. Additionally, depreciation policies may also differ between companies, too, with one following the straight-line methodStraight-line MethodStraight Line Depreciation Method is one of the most popular methods of depreciation where the asset uniformly depreciates over its useful life and the cost of the asset is evenly spread over its useful and functional life. and other with the accelerated depreciationAccelerated DepreciationAccelerated depreciation is a way of depreciating assets at a faster rate than the straight-line method, resulting in higher depreciation expenses in the early years of the asset's useful life than in the later years. The assumption that assets are more productive in the early years than in later years is the main motivation for using this method. method. Therefore in order to make the right comparison, EV to EBITDA is the correct valuation multiple in this case.
Other sectors where we should avoid using EV to EBIT (preferable use EV to EBITDAEV To EBITDAEV to EBITDA is the ratio between enterprise value and earnings before interest, taxes, depreciation, and amortization that helps the investor in the valuation of the company at a very subtle level by allowing the investor to compare a specific company to the peer company in the industry as a whole, or other comparative industries.) are the high capital intensive sectors like –
- Automobile Sector
The EV-to-EBIT multiple has a unique benefit of valuing a firm despite its capital arrangement that makes the ratio so attractive among the analysts.