One of the problems of investing is the multitude of tools and techniques available to analyze companies and the resultant confusion in making decisions. No single ratio or method in isolation can be used to pick promising stocks for investment. However, some of these ratios – like the beloved EV/EBIDTA - are more popular and hence it is important to know what are their advantages and disadvantages.
So what EV/EBIDTA mean? Lets understand in plain English. EV/EBITDA stands for Enterprise Value divided by Earnings Before Interest, Taxes, Depreciation and Amortization.
Enterprise Value (EV): To calculate EV, you start with a company’s market capitalization (the number of shares outstanding multiplied by its current market price). You then add the amount of total debt they hold, both short-term and long-term and then subtract the amount of cash and cash equivalents (like investments in liquid mutual fund units, etc) they have.
EBITDA: This is simply as the name suggests the company’s profits before deducting items like interest, taxes, depreciation and amortization.
That is all about the math, which is straight forward and simple. The reason this ratio is so popular is because it can be applied to almost any company - except airlines and banks. Thus, a company making losses at the net profit level is far easier to value compared to its peers based on EV/EBIDTA. The reason why EBIDTA is crucial is because it helps explain a business’s operating profitability. It vaguely helps gauge the contribution margin. It removes the impact of financial leverage and hence lends itself to comparison across various companies within and outside the company’s sector. Also, businesses which are in the nascent stage of build-out incur huge costs related to depreciation and interest expenses, which results in losses at net profit level. However, EBIDTA might help gauge the true margin power of the business.
However, the good news ends here. The ratio has been a subject of abuse in many valuation reports and M&A explanations. Thus, while it is important to look at EBIDTA to judge the margin potential, we cannot exclude depreciation out of the picture, as it is an implicit cost to use the fixed assets. Just imagine, would the business be able to operate without the use of fixed assets? Thus, ‘sustainable’ margin potential can only be judged using EBIT (Earnings Before Interest and Taxes) margin.
The second most common mistake is to judge the valuation of a company using the absolute EV/EBIDTA number. Thus, while a 6x EV/EBIDTA might look cheap, it might that the company has low return on assets and uses a large asset base to generate the EBIDTA. Thus the ratio totally ignores the impact of return on assets and can give an incorrect picture of profitability.
According to us, EV/EBIT is a far superior ratio than EV/EBIDTA as it does away with most of the disadvantages of the latter. It gives due respect to cost of using assets, takes into account impact of return on asset and at the same time irons out the impact of financial leverage to lend itself to comparison