The EV/EBITDA ratio is a comparison of enterprise value and earnings before interest, taxes, depreciation and amortization. This is a very commonly used metric for estimating the business valuations. It compares the value of a company, inclusive of debt and other liabilities, to the actual cash earnings exclusive of the non-cash expenses.
This ratio is also known as “enterprise multiple” and “EBITDA multiple”. The enterprise multiple can be used compare the value of one company to the value of another company within the same industry. A lower enterprise multiple can be indicative of an undervaluation of a company.
The EV/EBITDA ratio is calculated by dividing the enterprise value (EV) by earnings before interest, taxes, depreciation, and amortization (EBITDA). This can be written as
EV/EBITDA Ratio = EV / EBITDA
The EV/EBITDA ratio is a better measure than the P/E ratio because it is not affected by changes in the capital structure. Consider a scenario in which a company raises equity finance and uses these funds to repay the loans. This will usually result in a lower earnings per share (EPS) and therefore a higher P/E ratio. But the EV/EBITDA ratio will not be affected by this change in capital structure. This means that the EV/EBITDA ratio cannot be manipulated by the changes in capital structure. Another benefit of the EV/EBITDA ratio is that it makes possible fair comparison of companies with different capital structures.
Another positive aspect to the EV/EBITDA ratio is that it removes the effect of non-cash expenses such as depreciation and amortization. These non-cash items are of less significance to the investors because they are ultimately interested in the cash flows.
Norms and Limits
The EV/EBITDA ratio is not usually appropriate for the comparison of companies in different industries. Capital requirements of other industries are different. Therefore, the EV/EBITDA ratio may not give reliable conclusions when comparing different industries.
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