What Does the EV / EBITDA Multiple Mean?
The EV / EBITDA Multiple compares the total value of a company’s operations (EV) relative to its earnings before interest, taxes, depreciation, and amortization (EBITDA). The EV / EBITDA multiple is frequently used in relative valuation to compare across companies in the same (or similar) sector.
- What is the EV / EBITDA multiple used to measure?
- Why is the EV / EBITDA one of the most commonly used valuation multiples?
- What are the benefits of using the EV / EBITDA multiple?
- Why do certain practitioners criticize the use of the EV / EBITDA multiple?
In This Article
EV / EBITDA Multiple Formula
The EV / EBITDA multiple answers the question of, “For each dollar of EBITDA generated by a company, how much are investors currently willing to pay?”
The enterprise value represents the debt-inclusive value of a company’s operations (i.e. unlevered) while EBITDA is also a capital structure neutral cash flow metric. The EV / EBITDA multiple is thus widely used to benchmark companies of varying degrees of financial leverage.
The formula for calculating the EV / EBITDA multiple comprises of dividing the enterprise value of a company by its earnings before interest, taxes, and depreciation & amortization.
The numerator, the enterprise value (EV), calculates the total value of a company’s operations, whereas EBITDA is a widely used proxy for a company’s core (unlevered) operating cash flows.
At their simplest, the two metrics can be calculated using the following formulas:
Since EV / EBITDA is categorized as an enterprise value multiple, you must ensure that both the numerator and denominator represent the same investor groups – which in this case, is ALL investor groups (e.g. common and preferred equity shareholders, debt lenders).
In other words, the cash flows must pertain to all providers of capital. For example, interest expense must NOT be deducted from the cash flow metric used here, as it is specific to one investor group, the lenders.
Unlike a levered metric such as the P/E ratio, the EV / EBITDA multiple accounts for the debt sitting on a company’s balance sheet.
And for that reason, EV / EBITDA is frequently used to value potential acquisition targets in M&A because it quantifies the amount of debt that the acquirer must assume (i.e. cash-free, debt-free).
EV / EBITDA Multiple Commentary Slide (Source: WSP Trading Comps Course)
Low vs High EV / EBITDA
A high EV / EBITDA multiple implies that the company is potentially overvalued, with the reverse being true for a low EV / EBITDA multiple.
Generally, the lower the EV-to-EBITDA ratio, the more attractive the company may be as a potential investment. A low EV-to-EBITDA ratio could signal that a stock is potentially undervalued.
However, there are no set rules on what determines a low or high EV / EBITDA valuation multiple because the answer is contingent on the industry that the target company (i.e. the business being valued) operates within.
For example, an EV / EBITDA multiple of 10.0x could be viewed as being on the higher end for a consumer goods company. However, a software company valued at 10.0x may even be on the lower end of the valuation range commonly found in the software industry.
Therefore, interpretations of valuation multiples are all relative and require more in-depth analyses before making a subjective decision on whether a company is undervalued, fairly valued, or overvalued.
Additionally, for that reason, comparisons of a company’s EV / EBITDA multiple should only be made amongst companies that share similar characteristics and operate in similar industries.
Limitations of EV / EBITDA
For the most part, much of the criticism surrounding the usage of the EV / EBITDA multiple is around the EBITDA metric.
To many industry practitioners, EBITDA is not an accurate representation of a company’s true cash flow profile and can be misleading at times, especially for companies that are highly capital intensive.
|EBITDA Pros||EBITDA Cons|
In certain scenarios, adjusted valuation multiples such as EV / (EBITDA – Capex) can be used instead, which is oftentimes seen in industries like the telecom industry where there is the need to account for capital expenditures due to the sheer degree of impact that capex has on the cash flows of companies in these types of industries.
Seth Klarman Commentary on EBITDA (Source: Margin of Safety)
There is also much debate regarding the topic of “adjusted” EBITDA about whether or not certain line items should be added back or not. One notable example would be stock-based compensation (SBC), as certain people view it as a straightforward non-cash add back whereas others focus more on the net dilutive impact it has.
But regardless of its shortcomings as a measure of profitability, EBITDA still removes the impact of non-cash expenses (e.g. depreciation and amortization) and remains one of the most commonly used proxies for operating cash flow.
Leverage and EV / EBITDA Relationship
If there are two virtually identical companies with their leverage ratios consisting of the sole difference (i.e. percentage of debt in the total capitalization), you’d expect the two EV / EBITDA multiples to be similar.
While these two companies are very unlikely to actually be the same, in theory, the enterprise value and EBITDA metrics are each independent of capital structure decisions, thus it makes sense that they would have similar EV / EBITDA multiples.
Excel Template Download
Now that we’ve covered the EV / EBITDA concept and formula, we can move on to an example calculation. To get started, fill out the form below for access to the file.
EV / EBITDA Example Calculation Steps
In our example exercise, we’ll be assuming three different scenarios for comparability, with the capital intensity of each company as the changing variable.
First, let’s begin with the financial data that applies to all companies (i.e. is being kept constant).
- Enterprise Value (EV): $400mm
- LTM EBIT: $40mm.
For all three companies, the value of the operations is $400mm while their operating income (EBIT) in the last twelve months (LTM) is $40mm.
With those data points, we can calculate the EV / LTM EBIT using the simple formula of:
- EV / LTM EBIT = $400mm EV / $40mm LTM EBIT
- EV / LTM EBIT = 10.0x
All three companies have an EV / LTM EBIT multiple of 10.0x – but now, we must account for D&A.
- Low Capital Intensity: D&A = $10mm
- Base Case: D&A = $25mm
- High Capital Intensity: D&A = $40mm
From the pattern above, we can recognize that the more capital intensive the company, the higher the D&A expense.
Using those listed D&A figures, we can add the applicable amount to EBIT to calculate the EBITDA for each company.
- Company A (Low): EBITDA = $40mm + $10mm = $50mm
- Company B (Base): EBITDA = $40mm + $25mm = $65mm
- Company C (High): EBITDA = $40mm + $40mm = $80mm
Now, we can calculate the EV / EBITDA multiples for each company on an LTM basis.
- Company A: $400mm EV / $50mm = 8.0x
- Company B: $400mm EV / $65mm = 6.2x
- Company C: $400mm EV / $80mm = 5.0x
So, from our example calculation, we can see just how impactful the non-cash add-back, D&A, can be on the EV / EBITDA valuation multiple of a company.
At the EV / EBIT level, the three companies are all valued at 10.0x, yet the EV / EBITDA multiple shows a different picture.
EBITDA is a non-GAAP measure, therefore it is imperative to remain consistent in the calculation of EBITDA, as well as be aware of which specific items are being added back. Otherwise, the comps-derived valuation is susceptible to being distorted by misleading, discretionary adjustments.