Question

explain the significance of Ev/Ebitda multiple in the valuation of the investment.

Answer 1

Before we discuss the significance of EV/EBITDA multiple, let’s first get to know what is EV or Enterprise value. Theoretically, it is nothing but the entire cost of a company if someone were to own it.

But, how to calculate an Enterprise value? Simply, add the company’s market capitalization, preferred stock, and outstanding debt and then subtract cash and cash equivalents found on the balance sheet.

Thus, Enterprise value is the cost that you have to bear for acquiring every single share of a company’s common stock, preferred stock and outstanding debt. On the other hand, cash is deducted because once you completely acquire the company, the cash automatically becomes yours.

EBITDA, by the way, stands for earnings before interest, taxes, depreciation and amortization. What it shows is that how well a company is doing financially. Especially in case of a young organization, it shows how much cash the company generates before paying its debts.

Here are the formulas:

Enterprise value (EV) = Common shares + Preferred shares + Debt – Cash and Cash equivalents

EBITDA = Earnings from Operation + Interest + Taxes + Depreciation + Amortizations

Now that we know about EV and EBITDA, let us look at the importance of the EV/EBITDA ratio or the Enterprise multiple.

Firstly, this metric is used to determine an organization’s return of investment. And why not? While the numerator shows the cost one need to bear for acquiring the company, the denominator indicates earnings from operations. And it’s clear that a lower enterprise multiple will indicate an undervalued company or whose securities are trading lower than its fair market value. Now, that’s a good buying opportunity, as shares of undervalued companies are anticipated to move north rapidly.

Some sceptics now may say that other valuation metrics like the price-to-earnings ratio (P/E ratio) is also used effectively to find out whether a particular company is overvalued or undervalued. But, the enterprise multiple is still a far better valuation metric than the P/E ratio. Here’s why –

Unlike the P/E ratio, the enterprise multiple considers the company’s debt. And why debt is important? Let us look at an example. If you have bought a company for $100,000 and the business had a debt of $20,000, then actually you have to spend $120,000. Initially, you may have given $100,000 to own the company but eventually you have to repay $20,000 out of the cash flow of the business.

Another positive factor about the enterprise multiple is that it ignores the effects of non-cash expenditures including depreciation and amortization. After all, investors are not much bothered with non-cash items; instead they focus more on cash flows. More cash flows show that the company’s liquid assets are increasing helping it to settle debts and other liabilities.