The last in our blog series on valuation multiples is the EV/EBITDA Ratio.
The EV/EBITDA ratio is the ratio of th Enterprise Valuation of the company compared to the EBITDA that the company generates.
From a definitional stand-point we get EV and EBITDA using the following calculations:
- EV: Add the market value of debt and the market value of equity and hybrids;
- EBITDA: Take Net Profit after tax, add back tax, interest, depreciation and amortisation, and any appropriate once-off or significant items. EBITDA stands for "Earnings before Interest, Tax, Depreciation, Amortisation.
The EV/EBITDA ratio is often used for comparing companies that have substantial capital investment requirements. Some reasons for this are:
- A company that has invested very heavily in fixed assets will have (in general) large depreciation expense, which is a non-cash expense. This means that earnings (NPAT) will not closely resemble the cash flow generating capability of the company.
- It is quite common for businesses with large fixed asset requirements to finance a large proportion of their asset bases with debt. This creates a large amount of financial leverage, and can create significant instability in NPAT compared to the level of instability in cash flow generation. As such EBITDA is used as a more capital neutral measure of earnings. Because the denominator is capital structure neutral, it therefore follows that the numerator should also be capital structure neutral.
Some Strengths of the EV/EBITDA ratio:
- It is capital structure neutral, so can be more useful for assessing the cost of acquiring the assets of the company in question than other ratios that are not capital structure neutral;
- It is relatively more stable than PE and PB ratios while still reflecting the operating performance (vs price) of the company, as EBITDA captures key influences of the operations of the company.
- It is useful for parties assessing the price they should pay to acquire a business, as usually debt facilities will have a "change of control" clause which requires the debt to be repaid if a company's ownership changes substantially.
Some Weaknesses of the EV/EBITDA ratio:
- It does not actually capture whether or not the company is making a profit after tax, or whether it is generating positive cash flow.
- A lot of companies do not have publicly traded debt and/or hybrids, so the fair value of the debt and hybrids can only be approximated by looking at the figures on the balance sheet. For companies with publicly traded debt and hybrids often both debt and hybrids will trade below face value.