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EV/EBITDA – Another way to value companies

William Ryder, Equity Analyst, explains how to value companies using EV/EBITDA.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

This article is more than 6 months old

It was correct at the time of publishing. Our views and any references to tax, investment and pension rules may have changed since then.

We’ve previously looked in depth at EBITDA – earnings before interest, taxes, depreciation and amortisation. It’s a rough and ready measure of the cash available to management for investment, interest payments and taxes.

Here we look at a common use of EBITDA – the EV/EBITDA ratio. Like the more familiar price to earnings (PE) ratio this is used to value businesses. But it uses enterprise value (EV) instead of price and EBITDA instead of earnings. As you will see, it’s useful when comparing companies with different amounts of debt. However, it should be remembered all ratios and measures should not be looked at in isolation.

Enterprise value

A company can fund its operations by borrowing money (debt) or selling shares in the business (equity). An enterprise value takes into account both debt and equity and is a measure of the total value of a company’s assets.

A company’s enterprise value is its market capitalisation plus its net outstanding debt.

Market capitalisation = share price x number of shares

So if a company has a share price of £1 and there are 100 million shares outstanding, the company’s market capitalisation is £100m.

Net debt = debt - cash

If the company has £50m of outstanding debt and £10m in cash then it has a net debt position of £40m. The simplest way to think of this is as management choosing to use the company’s cash to pay off the debt.

Enterprise value = market capitalisation + net debt

By adding market capitalisation and net debt together we get the enterprise value, in this case £140m. You can think of this as the amount of money you would need to buy all of the company’s shares and all of its debt. It’s a way to value the company’s operating business, or the value of the enterprise.

Companies with large debts will have an enterprise value that is often substantially more than their equity value. For example, when you buy a house from someone you don’t just buy out their equity – you also have to pay off the remaining mortgage.

On the other hand, companies with net cash might have an enterprise value that’s less than the market capitalisation.

Imagine you bought a shop for £100k, and then found £10k in the cash register. Really you’ve only paid £90k – the enterprise value.

Putting EV and EBITDA together

EBITDA is a measure of a company’s cash generation and, crucially, it’s before interest payments on debt have been made.

EV and EBITDA can be combined to form EV/EBITDA. Simply divide the enterprise value by EBITDA as in the example below.

Metric Company XYZ
Net Debt £40m
Market capitalisation £100m
Enterprise value (EV) £140m

As in our previous example, this company has a market capitalisation of £100m, net debt of £40m and therefore an enterprise value of £140m. If it also generates EBITDA of £20m, its EV/EBITDA number would be 7.

How investors can use EV/EBITDA

By itself EV/EBITDA doesn’t tell you very much – is an EV/EBITDA ratio of 7 high or low?

Different businesses command different valuations. For example, you would expect a highly profitable, growing and financially sound business to have a higher valuation than one that’s unprofitable or in weak financial shape.

It helps to compare EV/EBITDA ratios of companies in the same industry, and against the business’s own long-term average. EV/EBITDA is particularly useful when comparing companies that are essentially similar but have different amounts of debt.

However, all of the limitations of EBITDA apply equally to EV/EBITDA. One of the biggest is that EBITDA excludes Depreciation and Amortisation, which are measures of the amount of investment a business requires. This means EV/EBITDA may be less appropriate for capital-intensive companies.

All valuation methods have advantages and disadvantages, so there’s no failsafe method that’s right every time. Investors will often come to different conclusions.

Generally, we feel it is beneficial to look at more than one method to value investments and their future potential. You may already be aware of PE ratios and dividend yields and we believe EV/EBITDA can work best alongside these, rather than instead of them. EV/EBITDA can be one more tool in your belt to use when assessing a company.

Remember all investments and their income can fall as well as rise in value so you could get back less than you invest. If you are at all unsure seek advice.

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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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