EV/EBITDA ratio – what is it and what does it mean?

EV/EBITDA is a financial metric used to assess the value of a company. It stands for “Enterprise Value to Earnings Before Interest, Taxes, Depreciation, and Amortisation.” This ratio compares the total value of a company (Enterprise Value) to its earnings before certain deductions.

ev/ebitda

EV/EBITDA formula

The EV formula is :

EV=Market Capitalisation+Total DebtCash and Cash Equivalents

Where:

  • Market capitalisation: Calculated as the company's current share price multiplied by the total number of outstanding shares.
  • Total debt: Includes all short-term and long-term debts.
  • Cash and cash equivalents: Refers to all the company's liquid assets, including cash and assets that can be quickly converted into cash.

Meanwhile, EBITDA is calculated as:

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

Where:

  • Net income: The company's total earnings or profit.
  • Interest: The interest expense for the period.
  • Taxes: The tax expense for the period.
  • Depreciation: The allocation of the cost of physical assets over their useful life.
  • Amortisation: Similar to depreciation, but for intangible assets.

The EV/EBITDA ratio is used by investors and analysts to determine how a company is valued relative to its core earnings power. A lower ratio suggests a company might be undervalued relative to its earnings potential, while a higher ratio suggests it might be overvalued.

This ratio is often interpreted as showing the number of years it would take for a company to pay back the purchase price (its entire value, including shares and debt) using its EBITDA, assuming the EBITDA remains constant over time.

To put it simply, if a company has an EV/EBITDA ratio of 5, it means, in theory, that it could pay off the equivalent of its entire value in 5 years using its current EBITDA, assuming no change in EBITDA and that all EBITDA is used for this purpose.

An EV/EBITDA ratio between 6 and 9 is often considered normal or average in many industries, but this can vary significantly. The “normal” range depends on factors such as the industry sector, economic conditions, and specific company characteristics. Some industries naturally have higher or lower ratios due to their business models.

As with any financial metric, EV/EBITDA should be used as part of a broader analytical framework. It's important to consider other factors like market conditions, company growth prospects, debt levels, and operational efficiencies.

It is also interesting to observe the EV/EBIT ratio and compare it with the EV/EBITDA. The main difference is that EV/EBIT includes depreciation and amortisation expenses, while EV/EBITDA excludes them. Depreciation and amortisation are non-cash expenses that reduce the value of assets over time. By excluding these, EV/EBITDA can sometimes inflate a company's earnings compared to EV/EBIT.

The difference can shed light on the company's financial health and operational efficiency. A higher EV/EBIT ratio (compared to EV/EBITDA) could mean that the company's current earnings are significantly impacted by non-cash charges, which might not be sustainable in the long run.

For investors, this difference can influence investment decisions. A company with high depreciation and amortisation might have lower free cash flow, which could impact its ability to pay dividends, reduce debt, or invest in growth.

Advantages and disadvantages of EV/EBITDA ratio

Among the advantages of EV/EBITDA we can find:

  • It is a ratio that is useful for comparing two companies in the same sector.
  • By taking into account the EBITDA, the ratio focuses on the generation of profits from the business itself. Thus, factors that are out of the company's control, such as the tax rate, are not considered.
  • It takes into account total debt (at the time of calculating the value of the company), helping to shed light on a company's financial health.
  • It is relatively easy to calculate.

However, we must take into account some disadvantages:

  • Not useful for comparing companies in different sectors.
  • A low EV/EBITDA ratio is normal for industries that require heavy capital investments, such as manufacturing, telecommunications, or utilities. These industries often have large amounts of physical assets, which lead to higher depreciation costs.
  • Does not consider other expenses that could be relevant.
  • The ratio can change over time. A low or acceptable EV/EBITDA can then increase if the business starts to generate less profits. Remember that, if the EBITDA (the denominator) drops, the ratio increases.
  • If the stock price has fallen due to reduced demand, the value of the company (the numerator) also decreases. Consequently, the ratio decreases.

Example of EV/EBITDA ratio calculation

For the fictitious company ABC, the EV/EBITDA calculation is as follows. Please keep in mind that the following data is fictitious. For actual companies, you need to consult the company's financial statements to find each figure.

Suppose a company ABC has the following data:

  • Number of shares: 1,000
  • Share price: £4

Market Capitalisation: = 1,000 shares * £4/share = £4,000

Next, to calculate EV, we also need total debt and cash and cash equivalents. For this example, let's assume that total debt is £5,000 and cash and cash equivalents are £1,000.

Hence, to calculate EV:

EV = Market Capitalisation + Total Debt – Cash and Cash Equivalents

EV = £4,000 + £5,000 – £1,000 = £8,000

Next, you need to calculate EBITDA. The EBITDA for ABC Company can be calculated as follows:

  1. Net Income: £1,500
  2. Interest Expense: £200
  3. Tax Expense: £300
  4. Depreciation: £400
  5. Amortisation: £100

So, the EBITDA calculation would be:

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

EBITDA=£1,500+£200+£300+£400+£100=£2,500

Finally, the EV/EBITDA ratio is:

EV/EBITDA = £8,000/£2,500 = 3.2

Find out more about financial analysis

Summary

All in all, the EV/EBITDA ratio is a widely used financial metric in the field of corporate finance and investment analysis. It compares a company's total value to its operational earnings before accounting for interest, taxes, and non-cash expenses like depreciation and amortisation.

This ratio is particularly valuable for investors, financial analysts, and potential acquirers as it provides a clear picture of a company's operational profitability and efficiency, while also facilitating cross-sector comparisons by neutralising the effects of different capital structures and tax environments.

FAQs

Why is EV/EBITDA important?

EV/EBITDA is important because it provides a standardised way to compare the value and performance of different companies, regardless of their size or capital structure. It's especially useful for comparing companies within the same industry and is widely used by investors and analysts to determine if a company is undervalued or overvalued.

What is considered a good EV/EBITDA ratio?

A “good” EV/EBITDA ratio varies by industry, but generally, a lower ratio (e.g., below 10) could indicate a potentially undervalued company, while a higher ratio might suggest an overvalued one. However, this can vary greatly depending on the industry norms and economic conditions.

Can EV/EBITDA be used for all industries?

While EV/EBITDA is a versatile metric, it is more suitable for some industries than others. It works best for capital-intensive industries like manufacturing or utilities, as it excludes depreciation and amortisation, which are significant expenses in these sectors. However, it may be less appropriate for industries where these factors are not as influential, such as technology or service industries.

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