EV/EBITDA Ratio: Understanding, Calculation & Usage for Investing

Introduction

The EV/EBITDA ratio is a financial metric that helps investors determine the valuation of a company by dividing a company’s enterprise value by its earnings before interest, taxes, depreciation, and amortization. This post provides a comprehensive explanation of enterprise value and EBITDA and how they are used to calculate the EV/EBITDA ratio.

It also explores how to use this ratio to evaluate stocks for investing and provides examples of Indian stocks that are either undervalued or overvalued based on their EV/EBITDA ratios compared to their peers. Additionally, it discusses the advantages and limitations of using the EV/EBITDA ratio as a financial metric.

EV/EBITDA Ratio

Understanding the components of this ratio is critical to making informed investment decisions. Here, we will provide comprehensive explanations of both Enterprise Value and EBITDA.

What is Enterprise Value?

Enterprise value is a measure of a company’s total value, including its equity value, debt, and cash reserves. It represents the cost of acquiring the entire business, including both the equity and debt holders. To calculate enterprise value, you need to add the market cap of a company’s equity to the outstanding debt, and then subtract any cash and cash equivalents.

The formula for calculating enterprise value is:

Enterprise Value = Market cap of Equity + Total Debt – Cash and Cash Equivalents

The market cap of equity is the current share price multiplied by the number of outstanding shares. Total debt includes both short-term and long-term debt, while cash and cash equivalents include cash, marketable securities, and other liquid assets.

What is EBITDA?

EBITDA stands for earnings before interest, taxes, depreciation, and amortization. It is a measure of a company’s operating performance, and it helps investors understand how much cash a company is generating from its operations. EBITDA is calculated by adding back interest, taxes, depreciation, and amortization expenses to a company’s net income.

The formula for calculating EBITDA is:

EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization

Net income is a company’s revenue minus its expenses, including the cost of goods sold, operating expenses, and taxes. Interest expense is the cost of borrowing money, while taxes are the income taxes a company must pay. Depreciation and amortization expenses are non-cash expenses that account for the loss of value of assets over time.

How to Use EV/EBITDA Ratio to Evaluate Stock for Investing

EV/EBITDA Ratio is calculated by dividing a company’s Enterprise Value (EV) by its earnings before interest, taxes, depreciation, and amortization (EBITDA). By comparing the EV/EBITDA ratios of different companies, investors can gain valuable insights into a company’s relative valuation and identify potential investment opportunities.

To use the EV/EBITDA ratio to evaluate stocks for investing, investors should look for companies with low EV/EBITDA ratios, as these are typically considered undervalued and may represent good investment opportunities. Conversely, companies with high EV/EBITDA ratios are considered overvalued and may not be good investment opportunities.

Here are a few examples of Indian stocks that are either undervalued or overvalued based on their EV/EBITDA ratios compared to their peers:

Undervalued stock example: Bharat Electronics Limited (BEL)

Bharat Electronics Limited (BEL) is a leading Indian defense electronics company that produces a wide range of advanced electronics systems and equipment. As of March 2021, BEL had an EV/EBITDA ratio of 9.85, which is significantly lower than the industry average of around 19. This suggests that the stock is undervalued compared to its peers and may represent a good investment opportunity.

Overvalued stock example: Asian Paints Limited

Asian Paints Limited is a leading Indian paint company with a wide range of decorative and industrial paints and coatings. As of March 2021, Asian Paints had an EV/EBITDA ratio of around 56, which is higher than the industry average of around 29. This suggests that the stock may be overvalued compared to its peers and could be a risky investment opportunity.

Clear picture of Companies Financial Health

The EV/EBITDA ratio is a financial metric that can provide investors with a clear picture of a company’s financial health. It takes into account a company’s enterprise value (which includes both debt and equity) and EBITDA (which is earnings before interest, taxes, depreciation, and amortization).

By dividing the enterprise value by EBITDA, investors can get an idea of how much they are paying for the company’s earnings. It’s important to keep in mind that this ratio should be used in conjunction with other financial metrics and a thorough analysis of the company’s financial health, management, and competitive landscape.

Recent Examples of Takeovers:

Reliance Industries acquisition of Future Group: In 2020, Reliance Industries acquired Future Group, a leading retail company in India, for an EV/EBITDA multiple of around 19, which was close to the industry average at the time. Whereas reliance Industries  EV/EBITDA multiple at that time was 19.

Tata Sons acquisition of BigBasket: In 2021, Tata Sons acquired a majority stake in BigBasket, an online grocery delivery company, for an EV/EBITDA multiple of around 16, which was again close to the industry average.

Adani Ports and SEZ acquisition of Krishnapatnam Port: In 2020, Adani Ports and SEZ acquired Krishnapatnam Port, a leading port operator in India, for an EV/EBITDA multiple of around 13, which was slightly below the industry average at the time. Whereas at that time Adani ports and SEZ trading around EV/EBITDA multiple of around 16

Advantages and limitations of using the EV/EBITDA Ratio

Advantages of using the EV/EBITDA ratio include:

Enterprise Value: Unlike other financial metrics such as the Price to Earnings (P/E) ratio, the EV/EBITDA ratio takes into account a company’s enterprise value, which includes both equity and debt. This provides a more complete picture of a company’s value and financial health.

Comparison Across Industries: The EV/EBITDA ratio can be used to compare companies across industries, as it is independent of accounting methods and financing decisions.

Cash Flows: EBITDA is a good proxy for a company’s cash flows, as it removes the impact of non-operating items such as interest, taxes, depreciation, and amortization. This can be useful for companies with high capital expenditures or for those that are in a growth phase.

Takeover Potential: The EV/EBITDA ratio is often used by investors to evaluate the takeover potential of a company, as it provides an indication of how much a buyer would have to pay for a company’s earnings.

However, There are also some limitations of using the EV/EBITDA ratio, which include:

Industry Specific: The EV/EBITDA ratio may not be applicable to all industries, as some industries have higher capital expenditure requirements than others. For example, the EV/EBITDA ratio may not be suitable for evaluating companies in the technology sector, where high capital expenditures are often required.

No Accounting for Debt Servicing: The EV/EBITDA ratio does not take into account a company’s ability to service its debt, which can be important for highly leveraged companies.

Variability: The EV/EBITDA ratio can be highly variable from year to year, and can be impacted by temporary factors such as changes in commodity prices or interest rates.

Misleading Results: The EV/EBITDA ratio may sometimes produce misleading results, particularly for companies with negative EBITDA or those that are in a turnaround phase. In these cases, other financial metrics may be more appropriate for evaluating a company’s financial health.

However, it’s important for investors to keep in mind that the EV/EBITDA ratio is just one of many financial metrics to consider when making investment decisions. Other factors such as the company’s management, competitive landscape, and growth prospects must also be evaluated before making any investment decisions.

Additionally, investors should exercise caution when interpreting the EV/EBITDA ratio, as it can sometimes be affected by temporary factors that may not reflect the long-term prospects of the company.

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