What Is A EV/EBITDA Ratio? Definition And Calculation

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What Is Enterprise Value?

Enterprise value is a common calculation of a company’s worth that is more comprehensive than market capitalization. Enterprise value includes a company’s debt, thus giving a fuller picture of a firm’s total business value. This makes for better comparisons for firms across a given industry which have different leverage profiles.

Enterprise value is calculated by adding up a firm’s market capitalization, net debt (debt less cash), preferred stock, and minority interest.

What Is EBITDA And Where Is It Found?

EBITDA is an acronym which stands for earnings before interest, taxes, depreciation, and amortization. Investors often use EBITDA as a metric for calculating a company’s cash flows, or more specifically, the amount of cash it can generate that can then service debt and other financial obligations.

EBITDA can be calculated from the income statement of a company’s financial results. Seeking Alpha automatically calculates 10 years of EBITDA data for companies on its income statement pages. Companies often provide EBITDA results in their quarterly reports and financial presentations as well, as it is a widely used financial metric.

How Do You Calculate The EV/EBITDA Ratio?

The EV/EBITDA ratio is calculated by first finding the enterprise value and the EBITDA of a given firm. Then, simply divide the company’s enterprise value by that EBITDA figure. See the below example to understand how this works in practice.

EV/EBITDA Example

To see an example of EV/EBITDA in practice, consider the following hypothetical company. As of its latest reporting quarter, it had a market capitalization of $10 billion, as well as $1 billion of cash on its balance sheet, but $3 billion of long-term debt. Summing those out, the company had $2 billion of net debt. It had no minority interests or preferred shares outstanding.

Thus, the company would have an enterprise value of $12 billion, thanks to the $10 billion of market capitalization and the additional $2 billion of net debt.

On the earnings side of the ledger, let’s say that the company generated annual net income of $600 million, but after deductions of $100 million in interest expense, $200 million in taxes, and expenses of $50 million each for depreciation and amortization. This would imply that that the company’s annual EBITDA was $1 billion ($600 million of net income + $400 million of addbacks from interest, taxes, depreciation and amortization).

This hypothetical company would therefore have an EV/EBITDA of 12x (= $12 billion / $1 billion)

EV/EBITDA Ratio Versus Price/Earnings Ratio

For the above hypothetical example, the P/E ratio would be 16.7x ($10 billion market cap/$600 million earnings). However, the company would have an EV/EBITDA ratio of only 12x ($12 billion/$1 billion).

There’s no hard and fast rule as to whether a company will have a higher EV/EBITDA or P/E ratio. EBITDA will almost always be higher than net income. However, enterprise value could be higher or lower than market capitalization, depending on whether a company holds net cash, or uses debt.

Key fact: A company’s market capitalization and enterprise value would be equal if the cash balance equals the debt balance outstanding, assuming there were no minority interests or preferred shares outstanding.

Pros And Cons Of EV/EBITDA

While most investors first learn about EPS and the Price/Earnings ratio, EV/EBITDA has become a mainstream tool for financial analysis. It’s particularly popular for viewing a company through the lens of being an acquisition target. Private equity, after all, has access to funding and thus wants to know how much money a company could make without worrying about interest and non-cash expenses, since much of those figures are subject to being reworked when a company changes hands and takes on a new capital structure.

EV/EBITDA is also highly useful for analyzing different firms within the same industry that use a different capital structure. For example, if one retail chain owns all their stores while the other leases them, excluding the depreciation of store buildings could give investors a fairer comparison of their underlying economics.

A major issue with the EV/EBITDA ratio is that the costs excluded in an EBITDA calculation are, in fact, real expenses. Taxes and interest have to be paid, and depreciation is an actual expense as well. A firm that skimps on repairing its hard assets such as vehicles or buildings will likely fail to remain competitive against peers over the long haul.

All that to say that while EV/EBITDA is a useful contextual framework, it’s hardly a be-all and end-all calculation on its own, at least for equity investors. EBITDA was created with an eye toward how much leverage a business could maintain — specifically, how much interest a company could afford to pay for given its current cash flows. This is highly useful information from a lender or private equity investor’s standpoint, but could lead to incomplete or errant conclusions for common shareholders.

Another drawback to the EV/EBITDA valuation approach is that some companies have gotten more and more aggressive with the sorts of expenses they add back into their “adjusted” EBITDA calculations. This was particularly prevalent with tech stocks and special purpose acquisition companies (SPACs) over the past few years where folks were very generous in making adjustments to EBITDA. This likely helped lead investors to give overly optimistic valuations to these sorts of businesses.

Finally, some business, such as banks, in general should not be evaluated using EBITDA (nor EBIT), and therefore never valued according to an EV/EBITDA ratio. Banks make a large portion of their profits from the net interest spread, which is essentially interest income less interest expense. Ignoring (or adding back) interest expense would therefore unreasonably exaggerate the profitability view of a bank.

Important: EV/EBITDA can be a great metric for analyzing a company’s underlying cash flow generation capabilities. However, investors should keep a close eye on earnings as well, and make sure that reported EBITDA results turn into shareholder value creation over time.

What Types Of Companies Are Best Evaluated Via EV/EBITDA?

The obvious answer would be the cable and telecom industry, as that is where the measure originated from in the first place. Telecom is a perfect use case as the firms involved tend to be among the most heavily leveraged in the world, spending tens of billions of dollars to build and maintain their networks. That spending also comes with massive amounts of subsequent depreciation and amortization.

Using EV/EBITDA to compare telecom firms allows investors to get a comparative analysis across different industry participants despite their vastly different levels of debt, fixed assets, interest expense and so on.

The same principles that apply in telecom also work for many other industries with a large fixed asset component. Sectors such as airlines, trucking, and railroads are often analyzed using EV/EBITDA since these firms spend heavily on the vehicles which power their businesses, and often have large amounts of debt or financing to fund their operations.

EV/EBITDA is also common for companies in basic materials and manufacturing sectors were companies have to invest heavily in their mines, oil wells, chemical plants, factories and so on. These are sunk costs, as the capital to build one of these facilities is already spent. Depreciation of these fixed assets can be a major drag on earnings. However, for investors looking at the cash flow that these already-built assets can provide, EV/EBITDA can prove a much more useful metric than accounting earnings.

What Types Of Companies Shouldn’t Be Evaluated Via EV/EBITDA?

Investors can get into trouble when using EBITDA to analyze companies where capital expenditures are a large and recurring expense which can’t be paused.

For example, with something like a cruise line operator, depreciation is a tremendously real expense. An old cruise ship will no longer be able to attract customers, and at some point, its very seaworthiness would come into question. An investor probably shouldn’t just hand wave away depreciation as a non-cash expense; if a new cruise ship isn’t purchased in a timely manner, the business could cease to function.

There are many such industries where depreciation is not just an accounting consideration but rather a very real expense that comes with tangible consequences if ignored for long. Famed investor Warren Buffett highlighted this point in his 2000 shareholder letter:

“References to EBITDA make us shudder — does management think the tooth fairy pays for capital expenditures? We’re very suspicious of accounting methodology that is vague or unclear, since too often that means management wishes to hide something.”

There can be cases where depreciation is a non-cash expense that isn’t necessarily recurring. Think of something like real estate, where a building is often written down significantly due to aging, even though the value of the underlying land and structure can retain its value and perhaps appreciate. That said, in highly capital intensive industries where assets wear out quickly, one should use extra caution before trusting an EBITDA valuation ratio entirely in place of earnings.

Another pitfall can come with companies that have a financial element. As mentioned above, banks should not generally be evaluated via EBITDA or EV/EBITDA, as the addback of interest expense would skew the true profitability picture. Paying interest is a core part of their business model in terms of attracting deposits to fund the bank. Recently, some FinTech companies reported adjusted EBITDA metrics to investors in lieu of profits. This was eyebrow-raising, since these firms often were, in fact, paying sizable sums of interest to attract capital to fund their underlying operations as part of the business model. It arguably makes little sense to exclude interest from profitability calculations in such a case.

Bottom Line

EV/EBITDA can be a useful metric. However, it’s just one tool in a financial toolbox, and it’s one that has gotten quite popular in recent years. That has allowed some analysts to stretch its uses well beyond its original aim. EBITDA came about as a way of thinking about leverage on top of long-lived assets such as cable television networks. It can make for a useful quick-hand measurement of cash flow generation across firms within an industry. However, investors shouldn’t generalize EV/EBITDA ratios too much given their inherent drawbacks.