WHAT IS EV/EBITDA?

What is EV/EBITDA Useful For?

According to Peter Temple (Magic Numbers for Stock Investors, Wiley 2004), the definition of EV/EBITDA is as follows:

EV/EBITDA is shorthand for a valuation method similar to the price-earnings ratio (PE). It tries to gauge the value of the company by comparing one of the measures of its market value with a profit number derived from the income statement.

EV is enterprise value. It is the market capitalization plus debt minus cash. You can calculate market capitalization by taking the issued shares of a company and multiplying them by the stock price.

EBITDA is an acronym. It stands for earnings before interest, tax, depreciation, and amortization. It is 'operating income' or 'operating profit' after adding back the charges for depreciation of fixed assets and amortization of goodwill. The reason for disregarding these charges is that they do not involve an actual cash expense.

The Formulas

EV/EBITDA = (market capitalization + total debt - cash) / EBITDA

EBITDA = pre-tax profit + interest paid + depreciation + amortization

The Components

Enterprise value (EV) has four elements:

• Issued shares: (common stock outstanding) -- these are shares that have been issued and are publicly trading.
  
  
• Share (or stock) price-- this is the current market price of the stock quoted every day in the newspaper or on your broker web site.
  
  
• Multiply these two together to arrive at the company's current market capitalization. EV is market capitalization plus total debt minus cash.
  
  
• Total debt-- this is the total of long- and short-term debt issued by or owed by the company and its subsidiaries. You can find it on the balance sheet or on the separate 'bank borrowings and debt securities' table on all MASNET earnings announcements.
  
  
• Cash-- the cash and fixed deposits stated on the balance sheet or cash flow statement.

EBITDA-- you can calculate this with relative ease from information in the company's accounts (and earnings MASNET announcement or company Annual Report). Most income statements (profit and loss statements) follow a similar pattern, with sales at the top. The cost of materials and other external inputs is subtracted from this figure to arrive at gross profit. From gross profit, various operating expenses are deducted to arrive at operating profit. But there are some charges like depreciation of fixed assets and amortization (annual write-offs) of goodwill that are book entries rather than actual payments.

EBITDA is operating profit after adding back the specific non-cash items of depreciation and amortization.

What It Means

EV/EBITDA is used as a means of comparing companies with high levels of debt or lots of cash, or those that are making losses at the net income level, but not necessarily further up the profit and loss column. You can also use it for comparing companies in the same industry but in different countries.

EV is a way of valuing a company in the same way, irrespective of its capital structure. Excluding the impact of interest and tax, the taking of earnings before interest and tax (the EBIT in EBITDA) as the denominator of the fraction balances this up.

In other words, debt is added back on the one side (in the EV calculation), and interest on debt is added back on the other (in EBITDA). Also, using a figure taken before deducting tax means that international differences in company tax rates can be ignored when comparing companies.

Is adding back charges like depreciation and amortization valid? The case is easier to make for amortization. It is usually related to amortizing goodwill, an arbitrary policy introduced by accountants. Those seeking to exclude depreciation from the equation are on shakier ground. Depreciation reflects the fact that physical assets wear out and have to be replaced. So though it is a notional charge at the time it is made, depreciation is a marker for real cost that must be borne by the business. It mirrors a cash expense in the future, which will occur when the assets are replaced.

Whether valid or not, EV/EBITDA is now widely used. However, it needs to be treated with extreme care, especially where used to justify the stock market valuations of loss-making companies. For example, you may notice Chartered Semiconductor and UTAC discussing EBITDA quite a bit. If a company has sizeable income from partly-owned companies, an adjustment may need to be made for this too.

Credits: Much of this article content is borrowed from Peter Temple's book, Magic Num8ers for Stock Investors, Wiley 2004.