Why It Pays to Understand EV/EBITDA

When most people start to research and make their own investments, they become aware of a few measures by which to assess a stock. Price is the most obvious, but soon they come to realize there has to be a framework to understand nominal price, such as how it relates to a company’s earnings.

That relationship is usually expressed as the Price to Earnings (P/E) ratio, a useful metric that gives a snapshot of value. If a stock’s P/E is lower than the average for other stocks in the industry, or the market as a whole, then it is considered “cheap.”

P/E, however, is not a perfect measure. It relies on the market price of a stock, which is often influenced by the subjective views of traders, and it ignores debt and cash on hand, which are obviously important in many cases. Nor does it take into account positive cash flow that may benefit a company without translating directly to bottom line profit.

That is why many analysts use another measure, EV/EBITDA, either alone or in conjunction with P/E when assessing a company.

What is EV/EBITDA?

In many ways, EV/EBITDA is the same thing as P/E. It is a ratio that expresses the capitalization or overall value of a company in terms of its profits or earnings. EV/EBITDA, however, adds more to the equation on the company value side and takes some away on the earnings side.

EV stands for Enterprise Value, a number that is calculated by adding together a company’s capitalization (the total market value of its shares) and its debt, and then subtracting the amount of cash it holds. At first glance, it may seem like adding debt and subtracting cash is a kind of backwards way to get a valuation, but it makes sense when you understand the purpose of EV. It is often used to calculate the value of a company for a proposed takeover, so incorporating debt that must be paid off but subtracting cash on hand is necessary to get a real picture of what the company’s sale price should be.

EBITDA, the other side of the ratio, stands for Earnings Before Interest, Taxes, Depreciation and Amortization. All of those things are included in a company’s published bottom line earnings, as are things like capital expenditure that are optional uses for cash. EBITDA is therefore a simpler measure of cash flow than earnings, reflecting sales and other direct income minus fixed and variable overheads, the basic costs of goods, labor and doing business.

Why Is EV/EBITDA Useful?

EV/EBITDA is a more comprehensive measure of a company’s value than P/E. It gives a clearer sense of its real monetary worth. On the EV or “price” side, it includes debt and cash on hand, both of which will impact a company’s real value to a potential buyer but aren’t reflected in the stock price. Meanwhile EBITDA ignores some non-cash items that may not affect the buyout value of a corporation. It is often said that the true value of something is only what people will pay for it, and EV/EBITDA, without the market distortions of the stock price and unavoidable non-cash expenses that are outside a company’s control, gives a better sense of that.

How To Evaluate and Use EV/EBITDA

As with P/E, a lower EV/EBITDA ratio than the average for the market and/or the particular industry in which a company operates is considered to indicate that the stock is probably undervalued. It is not enough, however, to just look at that one ratio to evaluate a company’s stock. For investors, it is important to understand that all valuation metrics have both advantages and disadvantages.

Perhaps the biggest disadvantage of EV/EBITDA is that it doesn’t take capital expenditure into account. Capex is a company’s investment in its future, but it is also a drag on current cash flow and bottom-line earnings. Depending on things like the state of the market in which a company operates and what they are spending their money on, capex can be a crucial expense, either adding or subtracting value.

However, EV/EBITDA gives a much better view of a company’s real-world worth than P/E, so it is an important tool for investors to understand and use on a regular basis. It is best used in conjunction with the simpler, but more widely used P/E ratio. The simplest way to think of the two metrics is as measures of market value. Taken together, they will give a complete picture of how the market is under or over valuing a stock, and therefore whether or not it will turn out to be a good or not so good long-term investment. That is what you are trying to assess when analyzing a stock, so it is important for investors to not just know what EV/EBITDA is, but to also incorporate it into their analysis.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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