Enterprise Value to EBITDA

Forbes  Mar 3  Comment 
Over the past few months we’ve covered how two of the three most popular valuation metrics—price to earnings and price to book—do a poor job of valuing stocks. Now we come to a metric that gets less attention but actually comes in as the...


EV / EBITDA equals a company's enterprise value divided by earnings before interest, tax, depreciation, and amortization.

Enterprise Value to EBITDA, or EV / EBITDA, is a measure of the cost of a stock which is more frequently valid for comparisons across companies than the price to earnings ratio. Like the P/E ratio, the EV / EBITDA ratio is a measure of how expensive a stock is. It measures the price (in the form of enterprise value) an investor pays for the benefit of the company's cash flow (in the form of EBITDA).

EV/EBITDA values can vary depending on how EBITDA is calculated. EBITDA can vary due to differences in acounting of depreciation and amortization which can be acounted at different rates over time.

Unlike P/E ratios, however, EV / EBITDA ratios can be used to compare a wide variety of companies.

P/E ratios can be an invalid way of comparing different companies for several reasons which are accounted for in EV / EBITDA. Among them:

EV / EBITDA is capital structure neutral

P/E ratios are impacted by a company's choice of capital structure - companies which raise money via debt will have lower P/Es (and therefore look cheaper) than companies that raise an equivalent amount of money by issuing shares, even though the two companies might have equivalent enterprise values (For example, if a company with debt were to raise money by issuing shares of stock, and then used the money to pay off the debt, this company's P/E ratio would shoot up because of the increased number of shares - although nothing about the fundamental value of the business has changed).

This makes it difficult to use P/E ratios to compare different companies with different amounts of leverage....

EV / EBITDA is unaffected by capital structure as enterprise value includes the value of debt, and EBITDA is available to all investors (debt and equity) as it excludes interest payments on that debt.

EV / EBITDA controls for different levels of capital expenditure required in different industries

For companies in industries which require big upfront investments or infrastructure (such as cable companies) and long gestation periods, EBITDA can be a more appropriate measure of the business's underlying profit potential since it excludes the cost of these investments.

Additionally, looking at cashflows prior to capital expenditures may provide a better estimate of 'optimal value', as the capital expenditures may be unwise or earn substandard returns.

EV / EBITDA is a better measure of a company's takeover value

EBITDA can indicate how attractive a leveraged buyout candidate the firm would be. In LBOs, the key factor is cash generated by the firm prior to discretionary expenditures, as it's this cash the buyer will use to pay off the loans he or she used to purchase the company, and EBITDA is the measure of cash flows from operations that can be used to support debt payment at least in the short term.

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