What is EV to EBITDA?
EV (which is the sum of market capitalization, preferred shares, minority shares, debt minus cash) 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 certain company to the parallel company in the industry as a whole, or other comparative industries.
EV to EBITDA Multiple is a vital valuation metric used for measuring the value of the company with an objective of comparing its valuation with similar stocks in the sector and it is calculated by dividing the enterprise value (Current Market Cap + Debt + Minority Interest + preferred shares – cash) by EBITDA (earnings before interest, taxes, depreciation, and amortization) of the company.
I rate this multiple above PE Ratio! The values of EV and EBITDA are used to find the EV/EBITDA ratio of an organization, and this metric is widely used to analyze and measure an organization’s ROI, i.e., return of investment as well as its value.
We note that EV to EBITDA Multiple of Amazon is at around 29.6x, whereas for WalMart, it is around 7.6x. Does this mean that WallMart is trading cheap, and we should buy Walmart compared to Amazon?
In this detailed article on EV to EBITDA ratio, we look at the following topics –
- What is Enterprise Value?
- Understanding EBITDA
- EV to EBITDA ratio
- Forward vs. Trailing
- Calculating (Trailing & Forward)
- How to Find Target Price?
- Why EV to EBITDA is better than PE ratio?
- Significance of Enterprise Multiple
- Limitations of EV/EBITDA
- Which sectors are best suited for this valuation multiple?
- Alternative to EBITDA
What is Enterprise Value?
Enterprise Value, or EV, shows a company’s total valuation. EV is used as a better alternative to market capitalization. The value calculated as the 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. is considered better than market capitalization because it is calculated by adding more vital components to the value of market capitalization. The added components used in the EV calculation are debt, preferred interest, 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., and total cash and cash equivalentsCash And Cash EquivalentsCash and Cash Equivalents are assets that are short-term and highly liquid investments that can be readily converted into cash and have a low risk of price fluctuation. Cash and paper money, US Treasury bills, undeposited receipts, and Money Market funds are its examples. They are normally found as a line item on the top of the balance sheet asset. . The values of the debt, minority interest, and preferred interest are added with the calculated market capitalization value. At the same time, the total cash and cash equivalents are subtracted from the calculated value to get the Enterprise Value (EV).
We can thus write a basic formula for calculating the EV as follows:
EV = Market Cap + Debt + Minority Interest + Preference Shares – Cash & Cash Equivalents.
Theoretically, the calculated enterprise valueCalculated Enterprise ValueThe Enterprise Value Formula is an economic measure that reflects the entire value of the organization, including secured and unsecured creditors, equity and preference shareholders, and is more commonly employed in acquiring other businesses or merging two or more businesses to achieve synergy. Enterprise value Formula = Market Capitalization + Preferred stock + Outstanding Debt + Minority Interest – Cash & Cash Equivalents can be considered as the price or value at which the company is bought by an investor. In such a case, the buyer will have to take up the debt of the organization, too, as his responsibility. In other words, it is said that the particular value will be pocketed by him too.
The inclusion of debt is something that gives the Enterprise Value its added advantage for the purpose of organization value representation. It is because the debt is to be considered seriously when it comes to any takeover situation.
For example, it will be more profitable to acquire an organization with a market capitalization of say $10 million with no debt than acquiring an organization with the same market capitalization and a debt of $5 million. Apart from the debt, the enterprise value calculations also include other special components that are important in arriving at an accurate figure for the firm’s value.
Also, you can have a look at the critical differences between Enterprise Value vs. Market CapitalizationEnterprise Value Vs. Market CapitalizationMarket cap is the market value of a company’s stock. This financial metric assesses the value of a business based solely on the stock. Enterprise Value on the other side is a more comprehensive and alternative approach to measuring a company’s total value. .
EBITDA or earnings before interest, taxes, depreciation, and amortization is a measure used to get a representation of an organization’s financial performance. With the help of this, we can find out the potential of a particular firm in terms of the profit its operations can make.
We can write the formula for EBITDAFormula For EBITDAEBITDA is Earnings before interest, tax, depreciation, and amortization. Its formula calculates the company’s profitability derived by adding back interest expense, taxes, depreciation & amortization expense to net income. EBITDA = net income + interest expense + taxes + depreciation & amortization expense in simple terms as follows:
EBITDA = Operating Profit + Depreciation + Amortization
Here, the operating profit is equal to the net profit, interest, and taxes added together. The depreciation expense and amortization expense play a significant role in EBITDA calculation. So to understand the term EBITDA to the fullest, these two terms are explained in brief below:
- Depreciation: Depreciation is an accounting technique for allocating the cost of a tangible assetCost Of A Tangible AssetAny physical assets owned by a firm that can be quantified with reasonable ease and are used to carry out its business activities are defined as tangible assets. For example, a company's land, as well as any structures erected on it, furniture, machinery, and equipment. over its useful life. Businesses depreciate their long-term assets for both tax and accounting purposes. For tax purposes, businesses deduct the cost of the tangible assets they purchase as business expenses. But, businesses should depreciate these assets in accordance with IRS rules regarding how and when the deduction could be made.
- Amortization: Amortization can be explained as the paying off of debt with a fixed repayment schedule, in regular installments, over a particular amount of time. Two common examples of this are a mortgage and an automobile loan. It additionally refers to the spreading out of capital expenses for intangible assetsIntangible AssetsIntangible Assets are the identifiable assets which do not have a physical existence, i.e., you can't touch them, like goodwill, patents, copyrights, & franchise etc. They are considered as long-term or long-living assets as the Company utilizes them for over a year. , over a particular period of time, again for accounting and tax purposes.
EBITDA is actually net income with interest, taxes, depreciation, and amortization, further added back to it. EBITDA may be employed to analyze and compare the profitability of different organizations and industries as it eliminates the effects of financing and accounting decisions. EBITDA is commonly utilized in valuation ratios and compared to enterprise worth and revenue.
EBITDA is a Non-GAAP measure and is reported and used internally to measure the performance of the company.
EV to EBITDA ratio or the Enterprise Multiple
Now that we know about EV and EBITDA, we can look at how they are used to get the EV/EBITDA ratio or, in other words, the Enterprise Multiple. The EV/EBITDA ratio looks at a firm as a potential acquirer would, taking into consideration the company’s debt, which alternative multiples, like the price-to-earnings (P/E) ratioPrice-to-earnings (P/E) 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. , don’t embrace.
It can be calculated by the following formula:
Enterprise value Formula = Enterprise Value / EBITDA
EV to EBITDA – Forward vs. Trailing
EV to EBITDA 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 EV to EBITDA formula (TTM or Trailing Twelve Months) = Enterprise Value / EBITDA over the previous 12 months.
Likewise, the Forward EV to EBITDA formula = Enterprise Value / EBITDA over the next 12 months.
The key difference here is the EBITDA (denominator). We use the historical EBITDA in trailing EV to EBITDA and use forward or EBITDA forecast in the forward EV to EBITDA.
Let us look at the example of Amazon. Amazon’s trailing multiple is at 29.58x; however, its forward multiple is at around 22.76x.
Calculating EV to EBITDA (Trailing & Forward)
Let us take the example from the below table and calculate the Trailing and forward EV/EBITDA. The table is a typical comparable table with relevant competitors listed along with its financial metrics.
Let us calculated EV to EBITDA for Company BBB.
Enterprise Value Formula = Market Capitalization + Debt – Cash
Market Capitalization = Price x number of Shares
Market Capitalization (BBB) = 7 x 50 = $350 million
Enterprise Value (BBB) = 350 + 400 -100 = $650 million
Trailing Twelve Month EBITDA of BBB = $30
EV to EBITDA (TTM) = $650 / $30 = 21.7x
Likewise, if we want to find the forward multiple of BBB, we just need the EBITDA forecasts.
EV to EBITDA (forward – 2017E) = Enterprise Value / EBITDA (2017E)
EV to EBITDA (forward) = $650 / 33 = 19.7x
Some of the points to consider with respect to Trailing EV to EBITDA vs. Forward EV to EBITDA.
- If EBITDA is expected to grow, then the Forward multiple will be lower than the Historical or Trailing multiple. From the above table, AAA and BBB show an increase in EBITDA, and hence, their Forward EV to EBITDA is lower than the Trailing PE.
- On the other hand, if EBITDA is expected to decrease, then you will note that the Forward EV to EBITDA multiple will be higher than the Trailing multiple. It can be observed in Company DDD, whose Trailing EV to EBITDA was at 21.0x; however, Forward EV to EBITDA increased to 26.3x and 35.0x in 2017 and 2018, respectively,
- One should not only compare the Trailing multiple for valuation comparison between the two companies but also look at the Forward multiple to focus on Relative Value – whether the EV to EBITDA difference reflects the company’s long-term growth prospects and financial stability.
How to Find Target Price using EV to EBITDA
Now that we know how to calculate EV to EBITDA let us find the Target Price of the stock using this EV to EBITDA multiple.
We revisit the same comparable comp table that we used in the earlier example. We need to find the fair value of TTT that operates in the same sector as below.
We note that the average multiple of this sector is 42.2x (Trailing), 37.4x (forward – 2017E), and 34.9x (forward – 2018E). We could directly use these multiples to find the fair value of the Target Company (YYY).
However, we note that company FFF and GGG are outliers with EV to EBITDA multiple ranges that are too high. These outliers have dramatically increased the overall EV to EBITDA multiple in the sector. Using these averages will lead to incorrect and higher valuations.
The right approach here would be to remove these outliers and recalculate EV to EBITDA multiple. With this, we will remove any impact from these outliers, and a comparable table will be cohesive.
Recalculated average multiple of this sector are 19.2x (Trailing), 18.5x (forward – 2017E) and 19.3x (forward – 2018E).
We can use these multiples to find the Target PriceTarget PricePrice Target in the context of stock markets, means the expected valuation of a stock in the coming future and the valuation may be done either by the stock analysts or by the investors themselves. For an investor, price target reflects the price at which he will be willing to buy or sell the stock at a particular period of time or mark an exit from their current position. of YYY.
- EBITDA (YYY) is $50 million (ttm)
- EBITDA (YYY) is $60 million (2017E)
- Debt = $200 million
- Cash = $50 million
- Debt (2017E) = $175 million
- Cash (2017E) = $75 million
- Number of Shares is 100 million
Target Price (based on trailing multiple)
- Enterprise Value (YYY) = Sector Average x EBITDA (YYY)
- Enterprise Value (YYY) = 19.2 x 50 = $ 960.4 million.
- Equity ValueEquity ValueEquity Value, also known as market capitalization, is the sum-total of the values the shareholders have made available for the business and can be calculated by multiplying the market value per share by the total number of shares outstanding. = Enterprise Value – Debt + Cash
- Equity Value (YYY) = 960.4 – 200 + 50 = $ 810.4 million
- Fair Price x Number of Shares = $810.4
- Fair Price = 810.4/100 = $8.14
Target Price (based on forward multiple)
- Enterprise Value (YYY) = Sector Average x EBITDA (YYY)
- Enterprise Value (YYY) = 18.5 x 60 = $ 1109.9 million.
- Equity Value (2017E) = Enterprise Value – Debt (2017E) + Cash (2017E)
- Equity Value (YYY) = 1109.9 – 175 + 75 = $1009.9 million
- Fair Price x Number of Shares = $1009.9 million
- Fair Price = 1009.9 /100 = $10.09
Why EV to EBITDA is better than PE ratio?
EV to EBITDA is better in many ways that the PE ratio.
#1 – PE ratios can be gamed by Accounting; however, Gaming of EV to EBITDA is problematic!
It will become obvious with the help of an example.
There are two companies – AA and BB. We assume that both companies are identical in all ways (Business, Revenue, clients, competitors). Though this is no possible in the practical world, we assume this impractical assumption for the sake of this example.
We also assume the following –
- Current Share Price of AA and BB = $40
- Number of Shares OutstandingShares OutstandingOutstanding 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. of AA and BB = 100
In this case, you should not have any particular preference to buy a specific stock as the valuations of both the companies should be the same.
Introducing a slight complication here! Though all parameters are equal, we make an only change with respect to the depreciation policies used by each company. AA follows a Straight Line Depreciation Policy, and BB follows an accelerated depreciation policyFollows An Accelerated Depreciation PolicyAccelerated 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. . Straight-line charges equal depreciation over the useful life. Accelerated Deprecation policy charges higher depreciation in initial years and lower depreciation in final years.
Let us see what happens to their valuations?
As noted above, the PE ratio of AA is 22.9x, while the PE ratio of BB is 38.1x. So which one will you buy?
Given this information, we are inclined to favor AA as its PE multiple is lower. However, our very assumption that these two companies are identical twins and should command the same valuations is challenged because we used PE Ratio. It is one of the most significant limitations of the PE ratio.
This huge valuation problem is solved by EV to EBITDA.
Let us now look at the table below –
We note that the Enterprise value of AA and BB are the same (this is the core assumption of our example). From the table above, we note that the enterprise value is $4,400 million (for both).
Though PAT for AA and BB was different, we note that EBITDA is not affected by the depreciation policy usedThe Depreciation Policy UsedWhen you purchase a zero depreciation policy, you are purchasing insurance that protects your entire property and does not decrease in value over time. So your car will depreciate over time, but if you have an accident, you will receive the entire amount from the insurance company and they will not subtract the depreciation value of your car.. AA and BB have the same EBITDA of $400.
Calculating EV to EBITDA (AA & BB) $4400 / $400 = 11.0x
We note that EV/EBITDA of both AA and BB is the same at 11.0x and is in consonance with our core assumption that both companies are the same. Therefore it doesn’t matter which company you invest into!
#2 – Buybacks affect PE Ratio
PE ratio is inversely proportional to the Earnings Per ShareEarnings Per ShareEarnings Per Share (EPS) is a key financial metric that investors use to assess a company's performance and profitability before investing. It is calculated by dividing total earnings or total net income by the total number of outstanding shares. The higher the earnings per share (EPS), the more profitable the company is. of the company. If there is a buyback, then the total number of shares outstanding reduces, thereby increasing the EPS of the company (without any changes in the fundamentals of the company). This increased EPS lowers the PE ratio of the company.
Though most companies buyback sharesBuyback SharesShare buyback refers to the repurchase of the company’s own outstanding shares from the open market using the accumulated funds of the company to decrease the outstanding shares in the company’s balance sheet. This is done either to increase the value of the existing shares or to prevent various shareholders from controlling the company. as per the Share Buyback Agreement, however, one should be mindful that the management can adopt such measures to increase EPS without any positive change in the company’s fundamentals.
Significance of Enterprise Multiple
- Investors primarily use an organization’s EV/EBITDA ratio in order to determine whether a company is undervalued or overvalued. A low EV/EBITDA ratio value indicates that the particular organization may well be undervalued, and a high EV/EBITDA ratio value indicates that the organization may well be overvalued.
- An EV/EBITDA ratio is beneficial for transnational comparisons as it ignores the distorting effects of individual countries’ taxation policies.
- It is also employed to find out attractive takeover candidates since enterprise value also includes debt and is thus a much better metric than the market cap for mergers and acquisitions (M&A). An organization with a low EV/EBITDA ratio will be viewed as a decent takeover candidate.
- EV/EBITDA ratios vary based on the type of business. So this multiple should be compared only among similar businesses or should be compared to the average business generally. Expect higher EV/EBITDA ratios in high-growth industries, like biotech, and lower multiples in industries with slow growth, like railways.
- The EV/EBITDA ratio inherently includes assets, debt, as well as equity in its analysis as it includes the enterprise value and Earnings before Interest, Taxes, Depreciation, and Amortization values.
- An organization’s EV/EBITDA ratio provides a perfect depiction of total business performance. Equity analysts use the EV/EBITDA ratio very often when making investment choices.
For example, Denbury Resources INC., an oil and gas company primarily based in the US, reported its first-quarter financial performance on the 24th of June, 2016. Analysts derived and calculated the organization’s EV/EBITDA ratio. Denbury Resources had an adjusted EV/EBITA ratio of 5x. It had a forward EV/EBITDA ratio of 13x. Each of those EV/EBITDA ratios as compared to alternative organizations having a similar business and also to past organization multiples. The organization’s forward EV/EBITDA ratio of 13x was more than double the enterprise value at the same point in time in 2015. Analysts found that the increase was because of an expected decline in the organization’s EBITDA by 62%.
Limitations of EV/EBITDA
EV/EBITDA ratio is a useful ratio that stands above other traditional techniques similar to it. However, it does have certain drawbacks, which have to be known before using this metric to make sure you are less affected by them. The main drawback is the presence of EBITDA in the ratio. Here are some of the EBITDA’s drawbacks:
- EBITDA is actually a non-GAAP measure that allows a larger amount of discretion on what is and what is not added within the calculation. It also implies that organizations usually modify the things included in their EBITDA calculations from one reporting period to the other.
- EBITDA initially came into common use with leveraged buyoutsLeveraged BuyoutsLBO (Leveraged Buyout) analysis helps in determining the maximum value that a financial buyer could pay for the target company and the amount of debt that needs to be raised along with financial considerations like the present and future free cash flows of the target company, equity investors required hurdle rates and interest rates, financing structure and banking agreements that lenders require. in the Eighties. At that time, it had been employed to indicate the ability of an organization to service debt. As time passed, it became widespread in industries with expensive assets that had to be written down over long periods of time. EBITDA is currently commonly quoted by several firms, particularly within the tech. sector — even when it is not secured.
- A common misconception is that EBITDA represents cash earnings. Although EBITDA is a smart metric to judge profitability, it is not a measure of cash income. EBITDA also leaves out the money needed to fund the working capitalWorking CapitalWorking capital is the amount available to a company for day-to-day expenses. It's a measure of a company's liquidity, efficiency, and financial health, and it's calculated using a simple formula: "current assets (accounts receivables, cash, inventories of unfinished goods and raw materials) MINUS current liabilities (accounts payable, debt due in one year)" and also the replacement of previous equipment, which might be vital. Consequently, EBITDA is commonly used as an accounting gimmick to dress up a company’s earnings. When using this metric, it is vital that investors additionally look at alternative performance measures to make certain that the organization isn’t making an attempt to hide something with the EBITDA value.
Which sectors are best suited for valuation using EV to EBITDA
Generally, you can use EV to EBITDA valuation method to value capital intensive sectorsCapital Intensive SectorsCapital 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. like the following –
- Oil & Gas Sector
- Automobile Sector
- Cement Sector
- Steel Sector
- Energy Companies
However, EV/EBITDA cannot be used when the current cash flow is negative.
Alternative to EBITDA
There is something called as the adjusted adjusted-EBITDA in accounting parlance, which can be a better alternative of EBITDA because of having fewer drawbacks. Adjusted EBITDAAdjusted EBITDAAdjusted EBITDA (Earnings before Interest, Taxes, Depreciation, & Amortization) is a tool to measure a Company’s recurring earnings through deducting many irregular, non-recurring, & one-time items from EBITDA. is a metric calculated for an organization by adjusting its “top line” earnings, for extraordinary items, before deducting interest expense, taxes, and depreciation charges. It is often employed to compare similar firms and for the purpose of valuation.
Adjusted EBITDA differs from EBITDA in that adjusted EBITDA normalizes financial gains and expenses since different organizations might treat each kind of financial gains and expenses differently. By standardizing cash flows and discounting anomalies, which might occur, adjusted, or normalized, EBITDA can give a better measure of comparison while evaluating multiple organizations. The adjusted-EBITDA can be expressed in a formula as follows:
The adjusted-EBITDA can be expressed in a formula as follows:
Adjusted EBITDA = Net Income – Other Income + Interest + Taxes + Depreciation & Amortization + Other Non recurring charges
So when it comes to the calculation of the EV/EBITDA ratio for a business organization, the use of EBITDA value can be replaced by the use of adjusted-EBITDA value. The change is more preferable as the adjusted-EBITDA value has more accuracy than the simple EBITDA value.
Below is a snapshot of Square Adjusted EBITDA reported in its S1 registration document.
source: Square SEC Filings
EV/EBITDA ratio is an essential and widely used metric to analyze a company’s Total Value. This metric has been successful in solving the problems encountered while using the traditional metrics, like the PE ratio, and hence it is preferred over them.
Also, as this ratio is capital-structure-neutral, it can be effectively used to compare organizations with different ranges of leverage, which was not possible in the case of the simpler ratios.