What is EV/EBITDA? Meaning, Formula and How to Use it For Investing?

Investing in a company’s stock requires careful analysis. As an investor, you must understand a company’s current performance and what it’s poised to do in the coming days. While several metrics, such as price-to-earnings (P/E) and price-to-book (P/B) ratio, can help you do so, you can utilise another vital metric for your analysis – EV EBITDA ratio.

The EV to EBITDA ratio consists of enterprise value (EV) and earnings before interest, taxes, depreciation, and amortisation (EBITDA). EV/ EBITDA multiple is the ratio of Enterprise Value of a company to its Earnings Before Interest, Taxes, Amortisation and Depreciation. EV/ EBITDA multiple is often used in valuation of companies.

This blog offers a simple explanation of the EV EBITDA ratio that can help you understand EV EBITDA meaning, its calculation, and how to use it to analyse a company’s value and performance, among other aspects. Let’s get started.

What is Enterprise Value (EV)?

Enterprise value or EV shows a firm’s total value, which includes the market value of its equity, market value of det minus cash and cash equivalents. In other words, EV represents the cost of buying a company, including its debt and equity. To calculate a company’s EV, add total debt to its market capitalisation and subtract its cash. Its formula is:

EV = Market value of equity + Market value of debt – Cash & cash equivalents

What is EBITDA?

To understand EV EBITDA meaning in the share market, let’s understand the second component in the EV to EBITDA ratio— EBITDA. EBITDA reflects a company’s earnings before deducting certain expenses such as interest on loans, income taxes and non-cash costs such as depreciation and amortisation.

Simply put, it shows the money a company generates from its core business operations. Investors often use EBITDA to analyse a company’s profitability, generate cash flow, and sustain operations.

A company with a high EBITDA usually indicates a strong and profitable business. EBITDA is also a valuable metric for comparing the financial performance of companies with varied capital structures and accounting methods.

What is the EV/EBITDA Ratio?

The EV/ EBITDA ratio is a financial ratio that can help you assess how much you pay for each rupee of EBITDA a company produces. The EV/EBITDA ratio formula is simple – EV divided by EBITDA. Let’s understand the EV/EBITDA multiple calculation with an example.

Suppose a company’s enterprise value is ₹1,000 crore and its annual EBITDA is ₹200 crore. The EV/EBITDA ratio would be 5 (1000 / 200). It means investors are willing to pay ₹5 for every ₹1 of the company’s EBITDA. If another company in the same industry has an EV EBITDA ratio of 8, it can indicate that the first company is cheaper or undervalued.

How to Calculate EV/EBITDA Ratio?

Here’s the all-important question: How do we calculate EV/EBITDA? The calculation is simple: divide a company’s EV with its EBITDA.

To calculate a company’s EV:

• Get its financial statement, including balance sheet and income statement
• Calculate the company’s market cap by multiplying the outstanding shares with the current stock price
• To arrive at EV, add the market value of total debt and subtract the cash

To calculate EBITDA:

• Add a company’s non-operating expenses like amortisation, depreciation and taxes to its operating expenses.

Use the EV/ EBITDA formula (EV/ EBITDA) to calculate this ratio.

You can find EBITDA figures in a company’s annual report. Companies publish their annual reports on their portals for different financial years, from where you can easily download them. Hence, you don’t need to calculate it manually. Online calculators are also available to calculate this ratio.

Purpose of EV/EBITDA Ratio

Next we discuss how can do EV EBITDA analysis:

• Determine if a company is undervalued or overvalued in comparison to its peers.. While a lower ratio may indicate undervaluation, a higher ratio may indicate overvaluation.
• Assess a company’s operational efficiency for a better understanding of business prospects.
• Evaluate potential acquisition targets. A lower ratio may indicate a company as an attractive acquisition target, as it generates strong earnings compared to its valuation.
• Use it to benchmark a company’s performance against the industry average.

How to Use EV/EBITDA to Invest in a Company?

Now that you know the EV to EBITDA multiple meaning, here’s how to use it to invest in a company.

• Find the Ratio

Start by finding the EV/EBITDA ratio for the company you’re interested in. While you can calculate it manually, you can also use financial and research websites to find it. Look for the company’s stock and the section listing valuation ratios.

• Compare With Competitors

The EV to EBITDA ratio is meaningful when compared with similar companies in the same industry. If you’re evaluating a steel company, consider its competitors’ ratios.

A lower ratio might mean undervaluation. If the company has strong growth potential and good fundamentals, this could indicate an opportunity to invest. On the other hand, a higher ratio might mean the company is expensive, or investors expect significant future growth.

• Check the Industry Average

Every industry has its own typical EV/ EBITDA range. Look at the industry average for EV EBITDA and compare it to the company’s ratio. If a company’s ratio is far below the industry average, it might signal undervaluation. If it’s far above, it might be overpriced.

• Dig Deeper

Don’t stop at just the ratio. A low EV/ EBITDA might look like a bargain. However, it’s equally essential for you to ask:

• Does the company have too much debt? A high debt level can make a company risky, even if it looks cheap.
• Is the company growing? Check its revenue and profit trends over the last few years. A low ratio could mean the company isn’t growing fast enough.

You can look at the company’s financial health, management quality, and market position to find answers to the above questions. You can combine EV/ EBITDA interpretation with other metrics to make informed decisions.

Advantages and Disadvantages of EV/EBITDA

With the EV/EBITDA definition clear, here are the advantages and disadvantages of EV/ EBITDA:

Advantages

• It helps in quick comparison of companies of different sizes and structure
• As it considers EBITDA, it can help you evaluate how well a company is performing
• As EV includes debt, it can help you spot companies with manageable debt and high debt
• It can help you unearth hidden gems

Disadvantages

• It doesn’t tell you about a company’s bottom-line profits. A company may look cheap but still struggle to make money.
• A company with a low ratio may still face growth issues
• It doesn’t consider all factors, and hence, it’s vital to use it with other financial metrics

EV/ EBITDA Comparison

The table highlights the EV/EBITDA comparison of five hypothetical companies in the same sector along with the potential investment potential:

*The numbers used in this EV EBITDA multiple valuation example are for illustrative purposes only

What Enterprise Multiple Can Tell You?

The EV – EBITDA ratio, or an enterprise multiple, can tell you about a company’s financial health and value. It tells you how much investors will pay for each EBITDA rupee generated. While a low enterprise multiple may suggest that the company is undervalued, a high multiple may suggest overvaluation and that investors can expect high growth in the future.

A lower multiple may allow you to acquire the company’s shares at a relatively favourable price than a company with a higher multiple. A higher multiple may suggest optimism but raise the risk of a potential downturn.

Conclusion

EV/EBITDA is a valuable tool for assessing a company’s value based on its equity and debt. But just like any other metric, it has its limits. It is essential to use it alongside other financial ratios and consider the company’s overall situation. The key is to continue evaluating the business. Examine its growth potential, industry, and any other risks or opportunities it might face. This will give you a much clearer picture when deciding whether to invest.