Reader Question: How Do You Use EV/EBITDA?

by JT McGee

A reader wrote in to ask about enterprise value, and earnings before interest, taxes, and depreciation. Specifically, the question asked about using EV/EBITDA to value a business.

So, let’s get straight to answer of how EV and EBITDA work, and why they’re used to value companies.

Note: I’m going to cover EV/EBITDA generally. If you’re looking for its application to individual sectors, I’d suggest searching the internet for “Industry X” “primers.” Investment banks and equity research firms have training manuals hundreds of pages thick that go through every single thing you could ever want to know about any industry ever. I’m not saying that they’re out there, or that pirating is a good thing, or that I’ve jammed more than a few university printers to collect piles of these on free printing days at the library. I’m just saying that you can find everything on the internet, and these might just be available online.

Enterprise Value

A business can be funded with debt or equity – loans or ownership. Some companies are funded almost entirely with debt, others are funded almost entirely with equity. To calculate enterprise value, we take all the existing debt of a business and add it to the market value of the company’s stock.

So, a company that has $100 million in long-term debt and stock worth $100 million would have an enterprise value of $200 million. Enterprise value is a good way to see what the full cost of acquiring a company might be. Companies are delivered debt free, meaning the acquired company’s lenders are paid off and the new owner can finance the company however it wishes.

Note: To the fullest existent, EV = market value of the equity + (total debt + capitalized leases – cash and cash equivalents) + minority interest + preferred equity. I’m going to simplify the hell out of the examples, since this many variables does nothing to add to why people use EV/EBITDA and only adds complication without doing much else. Should you apply this formula to your own investments, use this much longer equation.

Since companies are delivered debt free, it’s important to know what the full cost of an acquisition would be including assumed debt. Enterprise value gives us that full cost.

EBITDA

Earnings before interest, taxes, depreciation and amortization is just that – earnings before all these costs. EBITDA gives us a baseline for earnings without accounting for capital structure – how the company is financed.

Debt comes with interest costs, which are tax deductible. Debt is also amortized. See, if we look at EBITDA, we look at earnings without consideration for how the firm is financed. When we combine the two, we get a way to value a company without taking into consideration its preference for debt or equity financing. The example below should help demonstrate the point.

Putting EV/EBITDA Together

You see, simple valuation models like price-earnings multiples (PE ratios) vastly favor companies that use a lot of debt. EV/EBITDA does not have that bias. Examples help.

Consider this example:

Company A owns real estate and it has…

  • $5 million in debt at 6% per year (interest only loan)
  • $5 million in stock
  • $2 million in EBITDA
  • Income taxes of 50% on all earnings
  • No depreciation expenses (let’s not complicate this further)

To calculate earnings we take EBITDA of $2 million, subtract $300,000 in interest expense, and then divide by 2 to account for a 50% tax rate. Earnings are $850,000 per year.

Company B owns real estate and it has…

  • $0 in debt
  • $10 million in stock
  • $2 million in EBITDA
  • Income taxes of 50% on all earnings
  • No depreciation expenses (let’s not complicate this further)

To calculate earnings we take EBITDA of $2 million, and since we only have taxes to pay, we divide by 2 to get our after tax income of $1 million.

See it to Believe it!

On a price-earnings valuation, company A trades for a PE of 5.88 (stock worth $5 million divided by earnings of $850,000). Company B trades for a PE of 10 ($10 million of stock divided by net earnings of $1 million).

On an EV/EBITDA basis, the companies are exactly the same! Company A and B both have an enterprise value (debt + equity) of $10 million, and both generate EBITDA of $2 million per year. They both have EV/EBITDA ratios of 5.

If you look at the PE ratios, though, it would appear that Company A (PE of 5.88) is substantially undervalued relative to Company B (PE of 10).

Think about this like a real estate investment you might make yourself. If you buy a home to rent with all equity, the return you get on your equity investment will be quite low. If you buy a home to rent with 10% equity and 90% debt, the return you get on your equity investment will be much higher.

You wouldn’t compare the returns from a rental house financed with 100% equity to one financed with 10% equity and 90% debt to determine which you should buy. Rather, you’d look at the possible rents minus operating costs (EBITDA) relative to the purchase price (enterprise value) of the home. This gives you a comparison that is capital structure neutral, just like EV/EBITDA models do for stocks.

EV/EBITDA is for control buyers

EV/EBITDA is most valuable to people who will own the whole company. You see, as a small fish in the big pond of Wall Street, you’re not going to own the whole company. You’re going to own a tiny fraction of a public company.

I like companies with low PE multiples and low EV/EBITDA ratios. I think it’s a pretty powerful combination, all else being equal. A low PE tells me that the equity provides a high return, so I’ll get a high return on my equity investment in the company. A low EV/EBITDA ratio tells me that the whole company is generating a lot of EBITDA relative to how much it would take to acquire the company, meaning my shares could soon be purchased from me at a premium in an acquisition.

A low EV/EBITDA is primed for a buyout offer. A low PE tells me virtually nothing about the potential for a buyout, since any buyer has to buy the whole company – and that includes assuming the debt in one way or another.

That’s enterprise value, EBITDA, and EV/EBITDA in a nutshell. All these ratios are worthless, however, if you do not understand how information flows from the income statement to the balance sheet, and then the cash flow statement. Buying a book like Analysis of Financial Statements for <$20 might just be the best investment you ever make. Finance loves ratios. But ratios are worthless if you don't understand why these ratios are important. The only way to know why these ratios are important is to know accounting.

{ 6 comments… read them below or add one }

Sam October 17, 2012 at 10:12

Excellent analysis JT! Good job giving an example of property and its leveraged and unleveraged returns.

Reply

JT McGee October 17, 2012 at 19:19

Thanks, Sam.

Reply

That Reader October 17, 2012 at 14:04

Thank you for your reply and this post. Like Sam said, the real estate example was clear and easy to understand.

I am looking at stocks from a new angle. I used P/Es to find good stocks before we exchanged emails. I never examined debt before to figure out when to buy a stock because I did not think it had an impact on what multiple is good for earnings. I thought lowest P/E stocks were the cheapest from what I read from basic investing guides.

Thanks again.

Reply

JT McGee October 17, 2012 at 19:20

PE can be a real screwball insofar as valuing a business. Hope this and the emails help. Best of luck in the wonderful game of Wall Street!

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William @ Drop Dead Money October 17, 2012 at 17:35

Good breakdown. Question for you: what’s the difference between Assets and EV? In the old days, they told us debt + equity = assets.

Is it: you add the difference between market cap and equity to both sides of that equation? So EV = assets + market cap premium?

Thanks

Reply

JT McGee October 17, 2012 at 19:11

I need to edit this article. I probably shouldn’t have mixed terms like that. There are two meanings to equity – shareholder’s equity in accounting and equity as in the ownership of the company.

So, debt + shareholder’s equity = assets on the accounting statement. That’s accounting. Said another way, debt + book value = assets. You’re right.

Debt + the market value of the equity (as in, the market cap of the stock) = Enterprise value. So, yes, EV = assets + market cap premium in my example.

If you really, really want to calculate EV/EBITDA in the fullest way possible, it’s EV = market value of the equity + (total debt + capitalized leases – cash and cash equivalents) + minority interest + preferred equity.

I didn’t have any of those extra variables in the example, just because it only complicates it without adding to the point that EV/EBITDA just finds the true unlevered returns of the company – the returns of the company without taking into consideration how the company is financed.

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