EV/EBITDA

In simple terms

EV/EBITDA compares the value of the whole business with its operating earnings before interest, tax, depreciation and amortisation.

An EV/EBITDA of 10 means the whole business, including its debt, is valued at ten years of EBITDA. Analysts use it widely to compare companies, and in takeovers, where buyers pay for the whole business.

Why it is useful

It matches like with like. Enterprise value is the value owed to lenders and shareholders together; EBITDA is earned before paying either of them. So the ratio is not distorted by how a company is financed, unlike P/E, which uses profit after interest and the value of the shares only.

It removes differences in depreciation. Companies depreciate assets over different lives and by different methods. EBITDA is before depreciation, so it is less affected by these accounting choices.

It works when net profit is distorted. Heavy interest, unusual tax charges or large depreciation can make net profit, and P/E, misleading; EBITDA can still be meaningful.

What EBITDA leaves out

EBITDA is useful, but it is not cash flow, and treating it as cash flow is a classic mistake.

• Capital expenditure. Depreciation is excluded because it is not a cash cost in the year, but the assets it reflects must eventually be replaced. A business that must spend most of its EBITDA on equipment produces little free cash flow.
• Tax. Taxes are real cash costs.
• Working capital. Growing businesses tie up cash in inventory and receivables.
• Lease payments, under accounting rules that put most leases on the balance sheet, are excluded from EBITDA, so lease-heavy businesses must include lease liabilities in EV to compare fairly.

EV/EBIT as a check

EV/EBIT uses operating profit after depreciation. It is a useful check when companies need very different amounts of reinvestment: depreciation is a rough proxy for the cost of maintaining assets, so deducting it penalises capital-hungry businesses that EV/EBITDA flatters.

When not to use EV/EBITDA

• Banks, lenders and insurers. Their debt is part of their operations, and interest is their main cost and revenue. Use P/B and ROA instead.
• Businesses with very different capital needs, unless you also check EV/EBIT and free cash flow.
• When EBITDA includes one-offs or is flattered by capitalising costs.
• Companies with negative or tiny EBITDA, where the ratio is meaningless.

Why it matters

EV/EBITDA corrects the most common flaw in P/E comparisons: ignoring debt. It is a standard tool in comparing peers and in takeover analysis. Understanding what it omits stops you from treating a capital-hungry, heavily indebted business as cheap because its EBITDA multiple is low.

Limitations

EBITDA is not defined by accounting standards, so companies' own "EBITDA" figures may exclude different items; recalculate from the income statement where possible. The ratio ignores growth, returns on capital and risk, so peers on the same multiple can deserve very different valuations. Use it with EV/EBIT, free cash flow yields and an understanding of the business.

Common mistakes

• Treating EBITDA as cash flow.
• Comparing EV/EBITDA for businesses with very different reinvestment needs without checking EV/EBIT.
• Using a company's "adjusted EBITDA" without checking what was excluded.
• Applying EV/EBITDA to banks.

Try it yourself

1. Choose two listed companies in the same industry, one with significant debt.
2. Calculate each one's enterprise value and EBITDA, and then EV/EBITDA and P/E.
3. Calculate EV/EBIT as well, using depreciation from the income statement.
4. Write a sentence on whether the ranking of the two companies changes between P/E, EV/EBITDA and EV/EBIT, and why.