Key Points
1. First, it helps to understand that EV/EBITDA originated in the world of private equity, where it was used by firms to evaluate the cost and potential earnings benefit of buying a given company.
2. EV/EBITDA is an abbreviaton for Enterprise Value / Earnings Before Interest, Taxes, Depreciation and Amortization.
3. The ratio is very similar to the Price/Earnings ratio. The numerator, Enterprise Value, is akin to the true acquisition price, while the denominator is an attempt to calculate earnings from operations.
4. Mathematically, the formula is as follows:
(Market Cap + Value of Preferred Shares + Minority Interest + Total Debt + Unfunded Liabilities - Cash - Associate Companies) / (Revenue - Cost of Goods Sold - Operating Expenses)
Here is a breakdown of those numbers:
Market capitalization: The price to buy all common shares
Preferred shares: These are shares that are paid out first in the event of an acquisition, and are a distinct class from common shares included in market market capitalization. Although it is technically an equity classification, it may help investors to think of preferred shares as a form of debt; these shareholders need to get paid out first in an acquisition, and then the common shareholders can get paid.
Minority interest: This is the percentage of any subsidiary that is NOT owned by the enterprise. While the subsidiary's entire earnings may be included in the EBITDA calculation, the enterprise may not own 100% of it; to adjust for this discrepancy, we add the value of the subsidiary that is not owned by the enterprise in.
Total debt: Because buying the enterprise means assuming the enterprise's debt, we add that in to determine the total cost of the acquisition.
Unfunded liabilities: This is another form of debt, but it may not be reflected on the balance sheet. Understanding the company's full obligations can help understand its true price.
Cash: Because buying the enterprise means getting access to its cash, we can subtract the amount of cash the enterprise has already when attempting to determine the price we are paying for it.
Associate Companies: Associate companies are like the inverse of minority interest: they represent other companies that enterprise may have a stake in as reported on the balance sheet, but can be liquidated. In Europe, they are categorized as "fixed financial assets."
The denominator is EBITDA: Earnings Before Interest, Taxes, Depreciation, and Amortization. This is essentially income from operations; mathematically, it can be expressed as:
Revenue - Cost of Goods Sold - Operating Expenses
5. According to a study by James O'Shaughnessy that examined US stocks from 1964 to 2009, the lowest 10% of stocks by EV/EBITDA did slightly outperform the lowest 10% of stocks by P/E by 0.3% on an annual compounded basis.
6. Warren Buffett's colleague Charlie Munger referred to EBITDA as a "bulls***" valuation indicator because it does not factor in amortization, depreciation, and interest -- important elements of a business. Advocates of EV/EBITDA suggest EBITDA is useful for valuing a business based on its core operations, especially when a takeover may result in accounting changes that alter elements of tax, interest, depreciation, and amortization expenses.
7. Because EV/EBITDA can be complicated to calculate, many screeners do not include them, and research sites often report EV/EBITDA metrics that vary by a fairly wide margin for the same stock.