What is EV/EBITDA?
Enterprise Value/EBITDA is a common valuation multiple used to value a company and provide useful comparisons between similar companies. It’s an Enterprise Value multiple so you must ensure the numerator is before adding cash and deducting debt, and the denominator is before interest income and interest expense. Enterprise value (EV) is relevant to all stakeholders (both debt and stockholders) and the denominator must also reflect this. You must be consistent between the numerator and the denominator.
Key Learning Points
- EV/EBITDA is a valuation multiple used to value a company and use as a comparison metric between similar companies
- EV or Enterprise Value is the value of the core business before any financial assets and the deduction of debt. In other words, it is unaffected by a company’s capital structure.
- EBITDA is earnings before interest, tax, depreciation and amortization and is recurring profit from the core operations of the business before the impact of depreciation and amortization
- EBITDA is a driver of value and before the impact of capital structure so must be used with a consistent multiple (EV)
- The multiple is unaffected by asset step ups, which could result in an increased depreciation charge incurred by the acquirer
- Companies operating in the same sector may have different accounting policies for the treatment of their fixed assets which can impact their reported earnings. The EV / EBITDA multiple ignores this and provides greater comparability between companies who operate in asset intensive industries.
To better understand the relationship between the numerator and the denominator we can line up the Enterprise Value to equity value bridge with the income statement:
If you use earnings above the interest line you must use Enterprise Value as your numerator.
Why Do Analysts Use EV/EBITDA So Much?
1: The Multiple is Unaffected by Capital Structure
Look at the two examples below:
In the first example, the company has a large cash balance. The cash adds an additional 80% of value to the Enterprise Value (800 / 1,000 = 80%), while the interest income only adds 8% of income to EBIT (8 / 100 = 8%). So the Price earnings multiple rises to 23.8x reflecting a weighted average of the EV/EBIT multiple, the multiples of cash to interest income (800 / 8 = 100x) less the impact of tax. In the first example, the PE multiple was 13.3x and now it has increased to 23.8x reflecting the higher amount of cash. If you are valuing the operational business for a potential acquisition then you are interested in the value of the operations and not the value of cash. The EV/EBIT or EV/EBITDA multiple will give you a consistent ratio irrespective of the amount of cash on the company’s balance sheet and will be a much more reliable valuation metric. Companies with high cash balances often trade on high PE multiples.
In the second example, the company has large amounts of debt. The debt claims 80% of the Enterprise Value, while only claiming 40% of the EBIT, so the end result is that the equity value falls by a lot more than the net income when we add cash balances. Companies with large amounts of debt balances often trade on low PE multiples, but again the EV/EBIT and EV/EBITDA multiples are consistent.
In summary, multiples using Enterprise Value and earnings above the interest lines are much more reliable valuation metrics than PE multiples if companies’ capital structures are different in the peer group. However, as many companies don’t hold large cash balances, and companies in the same sector have the same business risk, most gravitate towards a similar capital structure, which means PE multiples would be a reasonable approach to use.
2: EBITDA is Unaffected by Asset Step-ups
When a company acquires another company they must revalue the target company’s assets and liabilities and put any identifiable assets on the balance sheet. Often, old fixed assets are revalued and generate a lot more depreciation expense going forward. Also, when identifiable intangible assets with finite lives are put onto the balance sheet they must be amortized, generating significant amounts of additional depreciation and amortization.
So when comparing companies in a peer group and one company has grown by acquisition, the acquisitive company will have much more depreciation and amortization expense than a comparable company which has grown organically. The acquisitive company will show a much higher PE ratio as they expense all the additional depreciation and amortization. The company which has grown organically will trade on a relatively lower PE multiple. The EV/EBITDA ratio will be unaffected by prior acquisitions as all the amortization and depreciation is added back.
The issue of step-ups is the overriding factor in favoring EV/EBITDA multiples when comparing the value of companies in a peer group.
3: EBITDA Strips Out Differences Between Amortization and Depreciation Policies
Companies make reasonable judgments about the lives of fixed assets (PP&E) and intangibles when estimating the yearly depreciation and amortization expense. There is flexibility in making these estimates between companies in the same sector. A company choosing a longer life will see correspondingly lower depreciation and amortization. A company choosing a shorter life will see correspondingly higher depreciation and amortization. Depreciation and amortization are more important in industries with large fixed asset bases and significant purchases of intangibles.
For example, the oil and gas sector is asset-intensive. Compare BP’s depreciation policies with Exxon:
BP is depreciating service stations over 15 years, while Exxon is depreciating service stations over a 20 year period. There are other differences, but this is an example of the discretion accountants have.