As any long-suffering readers would know, I sporadically look at the key ratios (there are a lot around) you see most commonly cited in investment articles. Previously, I have investigated Price to Earnings parts 1 and 2, Earnings Yield, and EBIT to Enterprise Value; today it is the turn of another ratio that sounds about as appetising as a spoonful of thumb tacks: EV/EBITDA.
Why?
The Enterprise multiple is often used by potential acquirers to value a business, because it takes debt into account, something that is not factored into the P/E ratio. The main selling points of this multiple are as follows:
- Leveraged buyouts
EBITDA is often checked if leverage is being used for the buyout because it focuses on cash generated by the firm before interest payments, tax, and spending. That cash generated would be key to an acquirer because he or she would need it for their own debt and interest repayments. Note, however, that this is a “selling point” – there is a strong objection here in that it is illogical to look at cash generated before interest and taxes, because they are not optional. That said, neither is depreciation avoidable either; old widgets need to be replaced. - Loss makers
The multiple is sufficiently robust that it can be applied to companies that are losing money, because earnings before everything (as Buffett has referred to EBITDA) should still be positive. And, if not, well… just look elsewhere. - Management team impact
As the cash flows are considered before expenditure, it can give a measure of optimal value, which again might enable a potential acquirer to calculate what could be done with a company under a different management team or debt structure. - Capital structure neutral
It allows comparisons between companies that use different levels of gearing. It also allows for comparisons of companies in different tax regions.
What?
EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is the cash flow generated by a company’s operating assets, or operating profit with depreciation and amortization added back.
EV (Enterprise Value) measures the total value of a company, including debt. It is calculated as (Market Cap + Debt + Minority Interest + Preferred Shares) – (Cash + Cash Equivalents).
How?
Fortunately, having already looked at EBIT, calculating EBITDA does not take much longer – just add back depreciation and amortization (these can be found on the Cash Flow statement). If you are the trusting sort, or just lazy, Morningstar provide EBITDA at the bottom of the Income statement.
Enterprise Value is Market Cap + Debt + Minority Interest + Preferred Shares – Total Cash and Cash Equivalents.
Oh but!
Although a low EV/EBITDA might imply good value, the following must be considered:
- Are there significant capital expenditures coming up?
- Does the company have a much higher cost of capital than its competitors?
- Does the company have a much higher tax rate than its competitors?
- If using it to compare companies in different industries, do the companies have different capital requirements?
There are many other objections to use of both EBITDA and this multiple; see this article about EBITDA on Investopedia for an example. In fact, without the necessary accounting skills, I think that this ratio is probably best avoided. I am going to downgrade it from a key ratio to a redundant ratio.