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Have you considered using the EV/EBITDA ratio?

The Enterprise Value to Earnings before Interest, Taxes, Depreciation, and Amortization or in short, the EV/EBITDA ratio, compares a company's overall value to its annual cash earnings minus non-cash expenses.


Also known as the Enterprise Multiple, it is a popular valuation tool for investors. It assesses companies and understands how many times you need to pay for the company's EBITDA to acquire the entire business.


But why do we use enterprise value instead of market capitalization?


That is because the enterprise value provides a more comprehensive measure of a company's worth than just market capitalization.


While market cap only considers the value of common shares, enterprise value accounts for factors like debt, cash equivalents, minority stakes, and preferred shares.


The formula of enterprise value is market cap add total long-term debt and short-term debt minus cash and cash equivalents.

It is a theoretical takeover price, encompassing all aspects of the business. This makes comparing companies within an industry more insightful as it considers their different debt levels and cash reserves.


So how do you use EV/EBITDA?


You can use the ratio to compare companies within an industry based on value and earnings, excluding non-cash expenses.


You can use the ratio to assess undervaluation or overvaluation by comparing it to the company’s peers or historical averages. A low ratio compared to peers or historical averages indicates that a company might be undervalued.


However, there are no fixed standards for what low or high ratios are. The context depends on the industry.


Higher multiples are expected in high-growth industries and lower multiples in industries with slow growth. Therefore, interpretations of valuation multiples are all relative.


It is also useful for cross-border comparisons as it does not consider the distorting impacts of specific countries' tax policies.


Some investors even use this ratio to calculate the terminal value in a Discounted Cash Flow model or find a target price.


But there are a few limitations.


EBITDA, a non-GAAP measure, allows analysts to choose income and expenditure components, leading to variations in calculations. It is also criticized for being an inaccurate proxy for operating cash flow.


It is also hard to adjust for different growth rates and justify objectively what is “undervalued” and “overvalued.”


The biggest drawback: the ratio does not consider capital expenditures.


This means that it is less appropriate for capital-intensive industries. Conversely, it is more suitable for mature companies with minimal capital expenditures.


There are also certain businesses, like banks, which shouldn’t be evaluated using EBITDA and hence should never be valued using an EV/EBITDA ratio. This is because bank profits derive from the net interest spread, disregarding interest expense would distort the bank's profitability perspective.

Certain business such as banks shouldn't be evaluated using EBITDA and hence should never be valued using an EV/EBITDA ratio.


Now, if you can find a relatively undervalued company using EV/EBITDA, don’t get too excited! It could be a value trap.


Stocks with seemingly low multiples may create the illusion of a value investment, but underlying fundamentals may be weak. Investors often assume a stock's past performance predicts future returns, leading them to view a low multiple as an opportunity for a "cheap" purchase.


This is why even though EV/EBITDA is a useful metric, it is just one tool among many in finance.


Let me know in the comments if you have considered using the EV/EBITDA ratio.


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