The enterprise value to earnings before interest, taxes, depreciation, and amortization ratio,
or EV/EBITDA, is a mouthful. But, it’s also a tool that investors can use to help determine
if a stock is potentially under- or overvalued. EV/EBITDA compares the total value of a business
to its operating profits. The results can then be stacked up against other companies
to determine which company is a better value. Generally, the lower the number, the better.
EV/EBITDA is a common alternative to another popular valuation metric, the P/E ratio, because
it accounts for factors that the P/E ratio misses. In this video, we’ll break down the EV/EBITDA
ratio, how it’s calculated, and why investors may find it helpful.
Let’s start by learning how to calculate and use EV/EBITDA with an example.
Imagine we wanted to determine if a soft drink company has some fizz. It’s
currently trading at $56, but is that a good price? Determining the company’s EV/EBITDA
and then comparing it to similar company ratios could help determine if it’s over or undervalued.
To do this, first calculate the enterprise value, which accounts for the company’s equity,
debt, and cash. To figure this out, add the market cap, which is the total value of the
company’s outstanding shares multiplied by the price of the stock, to the total debt.
Then subtract the total cash and cash equivalents. This gives us an enterprise value of $270 billion.
The second part of the ratio is EBITDA, which stands for earnings before interest,
taxes, depreciation, and amortization. By excluding taxes and expenses,
EBITDA focuses on the profits that come from a company’s primary operating functions
and less on accounting practices. EBITDA can sometimes be found on the income statement,
but it’s not standard accounting practice to include it, so it may require some calculations.
To calculate EBITDA, start with earnings, or net income, and add back the taxes, interest expense,
depreciation, and amortization, which in this example leaves us with an EBITDA of $13 billion.
Finally, divide the EV of $270 billion by the EBITDA of $13 billion for a ratio
of 20.7. However, this number alone doesn’t tell us much. But now that we have the ratio,
we can compare it to its historical ratios to get a relative sense of the stock’s value.
So, compared to previous years, some investors may interpret a lower ratio of 20.7
as a sign the company is undervalued and potentially has some pop.
We can also compare the ratio to the soft drink industry average of 30. In
this case, it’s okay that our soda company is a little flat because the lower ratio could
indicate that’s the company is undervalued. EV/EBITDA is often compared to another popular
valuation metric the P/E, or price-to-earnings, ratio. Some investors prefer the EV/EBITDA ratio
because it accounts for factors that the P/E ratio doesn’t.
The P/E ratio compares the price of a stock to its earnings and tells investors how
much they’re paying for those earnings, but this approach has some issues. For instance,
to represent a company’s value, the P/E ratio only uses its market cap, not its debt.
Companies that have a large amount of debt may be putting their future earnings at risk. The
enterprise value may paint a more accurate picture because it accounts for both equity and debt.
Second, the P/E ratio measures earnings by using earnings per share, or EPS. These numbers can be
skewed by accounting practices for taxes, interest, depreciation, and amortization.
For example, they may choose between various ways of accounting for depreciation, or they
could delay the recognition of certain expenses. By excluding interest, taxes, depreciation,
and amortization, EV/EBITDA focuses on the revenue that is generated from the primary
operations of the business and not by tax breaks in certain countries. It also means that investors
can use the EV/EBITDA ratio to evaluate companies that are not generating a profit
to analyze the viability of the core business. However, EV/EBITDA does come with drawbacks.
For example, it doesn’t account for capital expenditures, which can be a major expense
that could hurt the company’s bottom line. The ratio is not immune to accounting
shenanigans either. For example, aggressive accounting for revenue streams, like recognizing
revenue before a service has been delivered, could make the ratio appear more favorable.
Also keep in mind that a low valuation ratio does not guarantee a good investment. Sometimes
low multiples are deserved because the company is not performing well.
This is why investors commonly use EV/EBITDA in conjunction with other analysis like a
discounted cash flow model. Looking at potential future earnings can help avoid a value trap.
Of course, the opposite can also be true. A high valuation may be justified if the
company exhibits a lot of growth potential. The EV/EBITDA ratio focuses on how a company
gets its money and how well it does at putting that money to work on its core business.
Combined with other valuation tools, EV/EBITDA can help investors find undervalued stocks.