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We note that EV to EBITDA Multiple of Amazon is at around 29.6x whereas EV to EBITDA of WalMart is at 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 or the Enterprise Multiple
- EV to EBITDA – Forward vs Trailing
- Calculating EV to EBITDA (Trailing & Forward)
- How to Find Target Price using EV to EBITDA
- Why EV to EBITDA is better than PE ratio?
- Significance of Enterprise Multiple
- Limitations of EV/EBITDA
- Which sectors are best suited for valuation using EV to EBITDA
- 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 Value 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 interest and total cash and cash equivalents. The values of the debt, minority interest and preferred interest are added with the calculated market capitalization value, while 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 value 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 which gives the Enterprise Value its added advantage for the purpose of organization value representation. This 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 which are important in arriving at an accurate figure for the firm’s value.
Also, you can have a look at the key differences between Enterprise Value vs Market Capitalization
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 EBITDA 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 major role in EBITDA calculation. So in order to understand about 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 asset 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 done.
- 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 assets, 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 analyse 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) ratio, don’t embrace.
This 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 in Investment BAnking Analysis.
- Trailing EV to EBITDA
- Forward EV to EBITDA
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 EV to EBITDA is at 29.58x, however, its forward EV to EBITDA is at around 22.76x.
Calculating EV to EBITDA (Trailing & Forward)
Let us take the example from the below table and calculate EV to EBITDA Trailing and EV to EBITDA forward. 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 EV to EBITDA forward 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 EV to EBITDA will be lower than the Historical or Trailing EV to EBITDA. From the above table, AAA and BBB show an increase in EBITDA and hence, their Forward EV to EBITDA are lower that the Trailing PE.
- On the other hand, if EBITDA is expected to decrease, then you will note that the Forward EV to EBITDA will be higher than the Trailing EV to EBITDA. This 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 EV to EBITDA for valuation comparison between the two companies but also look at the Forward EV to EBITDA to focus on Relative Value – whether the EV to EBITDA difference reflect 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 EV to EBITDA 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 of 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. With this we will remove any impact from these outliers and comparable table will be cohesive.
Recalculated average EV to EBITDA 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 Price 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 EV to EBITDA)
- Enterprise Value (YYY) = Sector Average x EBITDA (YYY)
- Enterprise Value (YYY) = 19.2 x 50 = $ 960.4 million.
- Equity Value = 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 EV to EBITDA)
- 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 PE ratio.
#1 – PE ratios can be gamed by Accounting, however, Gaming of EV to EBITDA is difficult!
This will become obvious with the help of an example.
There are two companies – AA and BB. We assume that both the 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 Outstanding 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 same.
Introducing slight complication here! Though all parameters are equal, we make an only change with respect the depreciation policies used by each company. AA follows Straight Line Depreciation Policy and BB follows accelerated depreciation policy. 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 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 same valuations is challenged because we used PE Ratio. This is one of the biggest limitation of 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 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 used. 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 same at 11.0x and is in consonance with our core assumption that both companies are 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 Share 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 fundamentals of the company). This increased EPS lowers the PE ratio of the company.
Though most companies buyback shares as per the Share Buyback Agreement, however, one should be mindful that the management can adopt such measure to increase EPS without any positive change in company’s fundamentals.
Significance of Enterprise Multiple
- Investors primarily uses 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 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 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 were compared to alternative organizations having 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 of 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 an effective 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 because of 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. This 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 buyouts 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 capital 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 sectors 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 less drawbacks. Adjusted EBITDA is a metric computed 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 in a different way. 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 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 important and widely used metric to analyze 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.