One of the most famous ratios used by value investors is the EV/EBITDA ratio, or the Enterprise Value to Earnings Before Interest, Tax, Depreciation, and Amortization ratio. Value investors use it to evaluate a company. The EV/EBITDA ratio is used with or instead of the P/E ratio. Let’s break down this ratio into two parts: Enterprise Value and EBITDA.
Breakdown of Enterprise Value (EV)
The EV stands for Enterprise Value as mentioned above. The enterprise value of a company is usually the price when a company is being acquired. During an acquisition, the acquiring firm takes on everything the company has, including its debt. The enterprise value is the combined market cap and debt of a company. The net debt is the debt minus the cash because it’s the debt that the acquiring firm will have to pay off after buying the company. This is because when the acquiring firm buys out a company, they take on the company’s debt.
Therefore, the acquiring firm must pay the company’s market cap to acquire all ownership in the company and the company’s net debt to agree to pay off the long-term and short-term debt, with the help of the acquired cash and cash equivalents. A simple equation for enterprise value is this:
Again, market capitalization is the market value of a public company’s total outstanding shares. Total debt is the combined total short-term and long-term debt of the company. Cash and cash equivalents are the liquid assets on the company’s books.
EBITDA stands for Earnings Before Interest, Tax, Depreciation, and Amortization. The lesser known term is amortization, which is the payments on assets or loans spread over time. EBITDA is important as it is a measure of profitability of a company. The value helps investors compare profitability between companies and analyze the companies. This value is very useful as it provides a raw and clear value of earnings as it removes extraneous factors such as interest, tax, depreciation, and amortization. EBITDA gained popularity from private equity investors because they used the value to determine whether or not companies could pay their debts in the near-future.
Using the EV/EBITDA Ratio
So why should investors use EV/EBITDA when there are simpler ways out there such as the P/E ratio? The biggest reason many value investors prefer the EV/EBITDA is that it is more comprehensive than the P in the P/E ratio. The P (stock price) can also be substituted with the market capitalization. This only takes the company’s value of equity (stocks) into account. It doesn’t include any contribution from banks or other lenders. Investors who prefer the EV/EBITDA ratio say that the EV takes into account the market cap as well as the net debt (the long and short-term borrowing minus cash on the balance sheet). EBITDA is more straightforward because nothing is stripped out of the profits. The E (earnings) in P/E is the profits after tax.
Essentially, investors like the comprehensiveness that the EV/EBITDA ratio offers compared to other ratios as it accounts for the value of all financing the company has received from both equity stakes and debt.
EV/EBITDA Ratio Example: Coca-Cola Co.
The best way to understand the meaning of the EV/EBITDA is through an example. Let’s take a look at the company Coca-Cola Co., a Warren Buffet favorite. The market cap for Coca-Cola is $203.09B as of August 23, 2020. The debt that the company had in 2019 was $41.1 B. The cash holdings of Coca Cola as of 2019 were $13.0 billion. This amounts to $28.1 B of net debt. This makes the enterprise value $231.19 billion.
Coca-Cola's EV ($231.19 Billion) / Coca-Cola's EBITDA ($11.45 Billion) = 20.19 EV/EBITDA ratio
The EV/EBITDA ratio for Coca-Cola Co. is 20.19. A healthy EV/EBITDA ratio for a company is less than 10. It can also indicate that a stock may be undervalued. The average EV/EBITDA ratio for the S&P 500 as of January 2020 is 14.20. Comparing the S&P 500 and Coca Cola’s EV/EBITDA shows that Coca Cola has an EV/EBITDA that is 6 points higher. As a result, Coca-Cola may be overpriced.
The EV/EBITDA ratio can be extremely useful when determining a company’s value. The reason for the usefulness of this ratio is that it takes into account specific factors that make it more comprehensive than the P/E ratio. These factors mainly include contribution from outside lenders rather than just from financing the company has received from equity stakes. The ratio provides a raw and clear value before all extra payments need to be paid. If investors are looking to determine a company’s value in a more comprehensive manner, EV/EBITDA is the ratio for them.