EV/EBITDA Ratio: Why Is the Enterprise Multiple Important?

In the world of corporate finance, EV/EBITDA is an acronym that stands for enterprise value to earnings before interest, taxes, depreciation, and amortization. It is sometimes called the enterprise multiple or EV/EBITDA multiple.

Professional investors calculate the EV/EBITDA multiple using data from a business's financial statements and balance sheet. As a general rule, a company with a high EV/EBITDA ratio may be overvalued at its current stock price. Conversely, a company with a low EV/EBITDA ratio may have too low a share price and would provide relative value for an investor.

EV stands for enterprise value. It is the numerator in an EV/EBITDA equation. It can be calculated using the formula:

Enterprise Value = Market Capitalization + Debt + Minority Interest + Preference Interest Expenses – All Cash and Cash Equivalents

The components of a company's enterprise value break down as follows:

• Market capitalization: Market capitalization (or market cap) is the company's share price times the number of shares.
• Debt: Debt in this context includes the short-term and long-term debts owed to lenders.
• Minority interest: Minority interest represents the total value of shares held by minority shareholders (those whose interest represents less than fifty percent of the company).
• Preferred interest: Preferred interest is paid to preferred shareholders.
• Cash: Cash and cash equivalents represent the liquid assets a business has on hand (with the exception of marketable securities).

EBITDA stands for "earnings before interest, taxes, depreciation, and amortization," meaning this metric considers net income before interest payments, taxes, and depreciation and amortization costs have been subtracted. It is the denominator in the EV/EBITDA equation and is a type of profit metric.

A company's EV/EBITDA ratio has several financial modeling applications.

• Comparing companies in the same industry: An EV/EBITDA ratio can be an efficient tool for comparing companies within the same industry. Most notably, this type of valuation multiple gets applied to capital-intensive manufacturing sectors. The steel industry, concrete industry, oil and gas industry, energy industry, and automobile industry use EV/EBITDA as a benchmark for determining the reasonable market value of a company.
• Finding an optimal stock price: Investors study a company's average EV/EBITDA ratio over a fixed period of time to determine a target price for stock purchases. This calculation can be done on a simple spreadsheet. In many cases, one company's EV/EBITDA ratio is compared to others in the same market sector to see what the going share price should be.
• Assessing value without considering capital structure: EV/EBITDA does not factor in interest, depreciation, or amortization, meaning it does not show how much of a company's capital structure is tied up in loans, capital expenditures, and tax obligations. This makes it a neutral metric when it comes to capital structure.

EV/EBITDA is just one of several valuation multiples that investors and acquirers consider when measuring the financial health of a business. In some cases, other metrics like the profit-to-earnings ratio (P/E ratio) or the earnings per share (EPS) can be more useful for investment bankers. Consider some of the ways EV/EBITDA is a limited valuation metric.

• Less relevant to equity investors: When it comes to equity value, some investors prefer the profit-to-earnings ratio as opposed to the EV/EBITDA ratio. A P/E ratio clearly compares the price-per-share of a company to the earnings-per-share, which provides a clearer portrait of long-term equity value.
• Does not reveal the cost of assets: The EV/EBITDA metric does not account for interest, taxes, depreciation, or amortization, which means it does not fully reveal the cost of income-generating assets. Free cash flow is a better metric for determining the costs of assets.

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