What Is EV/EBITDA? Meaning, Formula, How to Use EV/EBITDA to Invest?

In the stock market, the P/E ratio is the key for valuation in many sectors. It’s a highly popular financial metric, but it has inherent flaws. Another metric that often balances these shortcomings is the EV/EBITDA ratio. 

EV/EBITDA is a financial metric that evaluates a company’s value relative to its earnings before interest, taxes, depreciation, and amortisation. It’s calculated by dividing a company’s enterprise value (EV) by its EBITDA. 

This ratio helps investors assess how much they pay for each rupee of EBITDA a company produces. It’s favoured for its ability to normalise differences in capital structure, making it suitable for comparing firms across various industries. Additionally, it focuses on operational performance by excluding financing and accounting impacts. Let’s understand the ratio, starting with the basics:

What is EV/EBITDA?

EV/EBITDA is a financial metric used to assess company value and performance. It compares enterprise value (EV) to earnings before interest, taxes, depreciation, and amortisation (EBITDA) and is calculated by dividing EV by EBITDA.

Enterprise value sums a company’s equity and debt minus cash and equivalents. EBITDA reflects operational earnings before non-operating costs and non-cash charges. The ratio indicates the price investors pay per dollar of EBITDA.

EV/EBITDA serves as a valuation tool, adjusting for capital structure variances. This makes it suitable for cross-industry company comparisons. It offers a more precise measure of operational performance, ignoring financing and accounting influences.

What is EV?

EV, short for Enterprise Value, combines equity value with net debts. Net debts equal total debts minus cash on hand. EV reflects a company’s market capitalisation and existing financial obligations. It’s crucial for calculating the enterprise multiple.

Enterprise value is also known as firm value and asset value. It represents the total value of a company’s assets. The formula to calculate EV is:

EV = (Share price X Number of shares) + Total debts – Cash

With EV, you can compute the enterprise multiple to assess a company.

Return on equity: Highlights

EV/EBITDA gauges a company’s value and acquisition cost. Calculating the enterprise multiple requires both Enterprise Value and EBITDA. EV/EBITDA is commonly used to compare valuations across companies. The enterprise multiple also factors in company debt and cash levels to evaluate profitability.

What is EBITDA?

EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortisation. It shows a company’s earnings before subtracting taxes and other deductions.

EBITDA measures a company’s operational performance. The formula for calculating EBITDA is:

EBITDA = Net Income + Interest + Taxes + Depreciation + Amortisation

Alternatively,

EBITDA = Operating Profit + Depreciation + Amortisation

Use the most accessible formula for the available data.

Formula of EV/EBITDA

The EV/EBITDA formula is simple. Calculate enterprise value and operating profit first.

The formula is:

Enterprise multiple = EV / EBITDA

Here, EV stands for Enterprise Value; calculated as Market Capitalisation + Total Debts – Cash.

EBITDA means Earnings Before Interest, Taxes, Depreciation, and Amortisation.

Purpose of the EV/EBITDA Ratio

The EV/EBITDA multiple evaluates a company’s valuation and financial performance. Analysts and investors use it to determine the price per dollar of EBITDA. A high multiple might indicate an overvalued company, whereas a low one suggests undervaluation. 

This ratio also facilitates comparison across companies in the same industry by adjusting for capital structure differences. Overall, EV/EBITDA is vital for assessing financial health and growth potential.

Common Uses of EV/EBITDA

1. Assessing company value.
2. Spotting investment opportunities.
3. Comparing industry peers.

Additionally, this metric is crucial in mergers, acquisitions, debt refinancing, and IPOs.

How To Calculate EV/EBITDA Ratio?

To calculate EV/EBITDA, learn finance or accounting and practice financial statements.

Steps to Calculate EV/EBITDA and Value a Company:

1. Access financial statements like the balance sheet and income statement.
2. Determine market capitalisation by multiplying shares by their current price.
3. Add total debt, minority interest, and preferred stock to market cap.
4. Calculate EBITDA by adding depreciation, amortisation, and taxes to operating income.
5. Divide enterprise value by EBITDA to find the EV/EBITDA ratio.
6. Research similar companies in the industry for valuation comparison.
7. Evaluate the company’s growth potential, competitive position, and economic factors.
8. Apply a discount rate considering the time value of money and risk.
9. Adjust the EV/EBITDA ratio based on these assessments and market trends.
10. Use this revised ratio to estimate fair company value for investment decisions.

EV/EBITDA Comparison Table

The table below showcases a hypothetical EV/EBITDA comparison across five different companies, all valued in Indian Rupees. Each company maintains an EV/EBITDA ratio of 5x, suggesting that investors are consistently prepared to invest five times the EBITDA across various company sizes or industries. 

However, further analysis should incorporate factors like growth potential, market dynamics, and industry-specific elements to evaluate financial performance and growth opportunities fully.

Advantages and Disadvantages of EV/EBITDA

Advantages:

1. EV/EBITDA is a commonly used metric for assessing a company’s valuation and financial health.
2. It offers a holistic view of a company’s worth, incorporating its debt, equity, and operational earnings.
3. The metric is effective for comparing companies within the same industry or sector because it normalises differences in capital structure and accounting practices.
4. It serves as a crucial tool for evaluating investment opportunities and spotting companies that are either under or overvalued.

Disadvantages:

1. EV/EBITDA overlooks variations in growth potential, market dynamics, and competitive positioning of companies.
2. It can be skewed by one-time events, such as shifts in accounting standards or interest rate changes.
3. The metric may not suit companies with large non-cash expenses or those that exhibit erratic earnings patterns.

How to Use EV/EBITDA to Invest in a Company?

Just like the P/E ratio, a lower EV/EBITDA ratio generally indicates a better investment opportunity. If a stock has a low EV/EBITDA ratio compared to its peers, it may be undervalued, offering a potential valuation advantage when bought. Conversely, a high EV/EBITDA ratio compared to peers might indicate overvaluation. However, relying on a single metric is not advisable.

EV/EBITDA can be used alongside the P/E ratio since it also considers the company’s debt value. Follow these steps to use EV/EBITDA to analyse whether a company’s stock is worth investing in:

1. Identify the industry of the stock you want to analyse.
2. Find five to ten comparable companies in the same sector.
3. Gather at least three years of financial information for each company, including key financial ratios.
4. Check the EV/EBITDA ratio and other valuation ratios.
5. Compare the multiples to see how your company is positioned against its peers.

Example:

Consider the following financial ratios of five companies in the same sector:

The average EV/EBITDA of these companies is 12.12.

Companies A and B are trading at above-average EV/EBITDA, likely due to higher growth, better ROE, and ROCE. ROE is calculated by dividing net profit by the company’s equity capital, while ROCE considers total capital instead of just equity capital. Based on this data, Companies A and B might be considered the top choices.

Bottom Line

EV/EBITDA is a vital financial metric for evaluating a company’s value and operational performance. By comparing enterprise value to EBITDA, normalises differences in capital structures, making it suitable for cross-industry comparisons. 

This metric helps investors identify undervalued or overvalued companies, facilitating informed investment decisions. While useful, it should complement other metrics for a comprehensive assessment. 

Understanding and utilising EV/EBITDA can significantly enhance the stock market’s investment strategies and financial analysis. Ready to enhance your investment journey? Open a Demat account with Angel One now and start making informed decisions with ease!

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