EV/EBITDA and its Importance

EV/EBITDA is a valuation multiple that is often used in parallel with, or as an alternative to, the P/E ratio. The term EBITDA is an acronym for Earnings Before Interest, Taxes, Depreciation and Amortization. The main advantage of EV/EBITDA over the PE ratio is that it is unaffected by a company's capital structure. It compares the value of a business, free of debt, to earnings before interest.

If a business has debt, then a buyer of that business clearly needs to take account of that in valuing the business. EV includes the cost of paying off debt. EBITDA measures profits before interest and before the non-cash costs of depreciation and amortisation. EV/EBITDA is harder to calculate than PE. It does not take into account the cost of assets or the effects of tax. As it is used to look at the value of the business in EV terms it does not break this value down into the value of the debt and the value of the equity.

The first advantage of EV/EBITDA is that it is not affected by the capital structure of a company, in accordance with capital structure irrelevance. This is something that it shares with EV/EBIT and EV/EBITA. Consider what happens if a company issues shares and uses the money it raises to pay off its debt. This usually means that the EPS falls and the PE looks higher (i.e. the shares look more expensive). The EV/EBITDA should be unchanged. What the “before” and “after” cases here show is that it allows fair comparison of companies with different capital structures.

EV/EBITDA also strips out the effect of depreciation and amortisation. These are non-cash items, and it is ultimately cash flows that matter to investors.

When using EV/EBITDA it is important to ensure that both the EV and the EBITDA used are calculated for the same business. If a company has subsidiaries that are not fully owned, the statement of income shows the full amount of profits from but is adjusted lower down by subtracting minority interests. So the EBITDA calculated by starting from company's operating profits will be the EBITDA for the group, not the company. There are two common ways of adjusting for this:

·         Adjust the EV by adding the value of the shares of subsidiaries not owned by the company. The end result is an EV/EBITDA for the group. This becomes complicated if there are a lot of subsidiaries.

·         Include only the proportion of EBITDA in a subsidiary that belongs to the company. So if the company has a 75% stake in a subsidiary, only include 75% of the subsidiary's EBITDA in your calculation. This is simple for companies (such as many telecoms companies) that disclose proportionate EBITDA. Otherwise, it can become difficult if the subsidiaries' results are not separately available. It also needs the corresponding adjustment to EV. In the example above, only 75% of the subsidiary's debt would be included in the group EV.

Given these complications, a sum of parts valuation may be considered as an alternative for complex groups. EV/EBITDA could still be used to value each individual part of the group.

EV/EBITDA is usually inappropriate for comparisons of companies in different industries, as their capital expenditure requirements are different. Ideally one would substitute EBITDA minus maintenance capex (capital expenditure required if the business does not expand) for EBITDA, which is difficult. Alternatively, depreciation could be used as an inaccurate but easy proxy for maintenance capex which would mean using EV/EBITA.

Also, see EV/Sales and its Importance. See the space for more on Valuation Ratios......... 

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