Enterprise Value to EBITDA

Earnings before interest, taxes, depreciation, and amortization (EBITDA) is about as far down the income statement as you can go before you need to split up the spoils of business victory to investors. That would be interest for debtholders and eventually net income for stockholders.

What do you think this suggests about the effects of leverage on both EBITDA and net income?

No. It affects just one of the two. Think about two scenarios: having interest expense and not having interest expense.

No. The amount of debt financing is reflected in interest expense, directly affecting net income.

That's right! Whether there's a huge pile of debt or none at all, EBITDA is unaffected. But net income is found only after any interest expense deducted, and so it is directly affected. Of course investors also take leverage into account when pricing a stock; leverage means risk.

So while price multiples like P/E, P/S, P/CF, and P/WE (that's "price to whatever else," and not a real multiple) are popular measures of share value, there is a need to consider financial leverage when comparing one measure to another. And face it—a comparison is the main reason for using multiples. If you want to use EBITDA as the performance measure, what set of investors do you think would be most appropriate for using as a comparison of value?

No. Consider that EBITDA eventually becomes net income, which flows to stockholders.

No. Consider that EBITDA includes the payments made to debtholders.

Exactly! EBITDA has value for both debtholders and stockholders, so it is comparable to the total value of debt and equity—in other words, __enterprise value__.

The most popular enterprise value multiple is exactly this match: enterprise value to EBITDA. What's nice about EBITDA is that it not only removes differences in leverage but also in depreciation and amortization as well, since they are just accounting charges. But the downside of EBITDA is that it's not as good theoretically as free cash flow to the firm (FCFF), since capital expenditures are directly reflected there.

To find enterprise value, just add up the market values of common equity, preferred stock, and debt. Then subtract cash, cash equivalents, and short-term investments. Why do you think these liquid assets are removed?

No. Cash and equivalents are permanent accounts, and their value is certainly reflected in the market value of debt and equity.

Yes. You might even hear these called __nonearning assets__ sometime. For example, imagine a cashless firm with a market value of USD 100,000 for debt and equity combined, with USD 20,000 in EBITDA. That's a multiple of EV/EBITDA of five. Good, that's the information that you want. But now assume that the firm runs out and grabs another USD 900,000 of capital—maybe a large bank loan. So now it's a USD 1,000,000 firm with a multiple of 50? No. It may use that money to expand operations to 10 times its size, and then it will have 10 times the EBITDA. That's fine. But until then, this money is just an illusion. Or look at it another way. Someone buying the firm would need to spend a net amount of USD 100,000 in either case. So that's the firm's value.

No. Relative value isn't an issue. If 90% of the firm's assets were cash, it would still be removed in calculating enterprise value.

Calculating the EV/EBITDA ratio usually involves adding up the market capitalization for equity (remember that's the share price times the number of shares outstanding), then the market value of any preferred stock, and then the market value of debt if it's available. Often it's not, and debt is just taken from the balance sheet. Then this total is divided by some trailing measure of EBITDA, like 12 months trailing (TTM) using the current and last fiscal year. So if you have just the first quarter of this fiscal year's EBITDA as 50, and last fiscal year's EBITDA was 160, then the TTM would be $$\displaystyle 50 + \frac{3}{4}(160) = 170 $$.

If you want to find a justified EV/EBITDA measure, then you'll need a fundamental profitability measure. The __return on invested capital (ROIC)__ is the best choice here. It's operating profit after tax divided by total invested capital. What do you think makes it such a good match for the EV/EBITDA multiple?

No. Any profitability measure can be stated after tax. The key here is that it's based on all capital.

Of course.

A lower EV/EBITDA multiple suggests relative undervaluation, all else equal. As with any multiple you choose, all else is _never_ equal, so make sure you investigate differences when comparing this multiple to others in a peer group or even a company's own measure over time. It's a clue, but not a conclusion.

To summarize: [[summary]]

It affects just EBITDA

It affects just net income

It affects both EBITDA and net income

Just debt

Just equity

Both debt and equity

They are less valuable

They aren't used to earn EBITDA

They are temporary accounts and not reflected in debt or equity

It's after tax

It's based on all capital

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