NaAtMaD – News and Articles that Make a Difference

2 interesting articles which compare this ratio :

by Hindu:
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How retail investors can profit from EV/EBITDA?

D. Murali

Equity share valuation is all about choosing the suitable multiple, says Mr Sanjiv Agrawal, Partner and National Head – Valuation Services, Ernst & Young. “Across the financial press targeted at retail investors, one factor that strikes a corporate analyst is the focus on price earnings (PE) multiple with minimal importance given to other multiples, enterprise value/earnings before interest, tax and depreciation & amortisation (EV/EBITDA) multiple in particular,” he observes.

Here is Mr Agrawal’s take on a few questions from Business Line.

What is the reason for the common bias towards PE multiple?

This may be attributable to the fact that PE multiple is relatively easier to calculate based on published results of listed companies compared to the EV/EBITDA multiple. In contrast, most analysts would swear by EV/EBITDA multiple.

Why so?

In our view, the EV/EBITDA is a smarter ratio to be used as part of comparable multiples analysis. Smarter, because it is purely driven by business operations of the company unlike PE multiple, which additionally gets impacted by non-business factors of discretionary or non-recurring nature. Non-business factors are usually less predictable from retail investors’ point of view.

PE is so simple to calculate: Price per share divided by the EPS (earnings per share). And you are bashing it?

Simple to calculate, yes; but it has several deficiencies, especially in the Indian context. Most Indian companies’ P&L (profit and loss) accounts feature significant `other income’, which is usually not related to business operations and varies a lot from year to year.

Also, by definition, growth drivers and risk factors of `other income’ are quite different from income from business operations. A key item is income from investments, which is driven mainly by interest rate scenario, investments sale activity during the year, and also non-market rate related investments made by the company (in related entities).

If we decide to switch to the alternative, that is, the EV/EBITDA multiple, how do we go about the exercise?

It should first be noted that the EV/EBITDA multiple, being a brilliant metric, is more tedious to compute than the PE multiple. EBITDA, the denominator, overcomes all the deficiencies that PE suffers from. But, one needs to make some adjustments…

Such as?

Add back to `net profit after tax’ the charge for depreciation, interest and tax, and also remove the non-operating/non-recurring items of income/expense.

The removal of latter items may not be easily possible as requisite information is not very transparent in annual accounts as per Indian company law format.

Making adjustments to the price, i.e. market cap is a little more tedious in fact. One needs to reduce market value of non-operating assets (e.g. surplus properties, investments, loans to group companies) from market cap. Loan funds borrowed by the company need to be added to the market cap to arrive at EV, the enterprise value.

On how the metric can be put to use.

The EV/EBITDA multiple can be compared to probe real (business) or market imperfection related reasons for differences in EV/EBITDA multiple across various comparable companies. A similar PE multiple analysis will not be amenable to this probing.

For example?

Two companies in a sector may have similar PE multiple but very different EV/EBITDA multiple. A PE multiple analysis may suggest that both are similarly valued by the market whereas in reality EV/EBITDA multiple analysis will highlight use of very different multiples for business valuation of the two companies by the market.

EV/EBITDA multiple analysis may upon further probing suggest that market will likely in future work towards converging both companies’ EV/EBITDA multiple to a similar level (assuming broad operating similarities in the companies), providing basis for buy or sell investment opportunities.

And, in the converse?

On the converse, similar EV/EBITDA multiples but very different PE multiples may not suggest converging of both companies’ PE multiples. The divergence of PE multiples may be due to non-operational reasons.

For instance, the company with lower PE multiple may have invested significant sums in related entities with lower than market returns. And so, the latter will not yield any significant buy/sell opportunity for an investor.

The bottom line, therefore?

EV/EBITDA ratio’s increased usage would benefit capital markets also as retail investors appraise corporate managements more effectively while making smarter investment decisions for themselves.

We need to help retail investors by providing this ratio to them periodically.

© Copyright 2000 – 2006 The Hindu Business Line

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EV/EBITDA

EV/EBITDA is one of the most widely used valuation ratios. It is:

EV ÷EBITDA

The main advantage of EV/EBITDA over the PE ratio ratio is that it is unaffected by a company’s capital structure. It compares the value of a business, free of debt, to earnings before interest.

If a business has debt, then a buyer of that business (which is what a potential shareholder is) clearly needs to take account of that in valuing the business. EV includes the cost of paying off debt. EBITDA measures profits before interest and before the non-cash costs of depreciation and amortisation.

EV/EBITDA is harder to calculate than PE. It does not take into account the cost of assets or the effects of tax. As it is used to look at the value of the business in EV terms it does not break this value down into the value of the debt and the value of the equity.

As EV/EBITDA is generally used to value shares it is assumed that debt (such as bonds) that has a verifiable market value is worth its market value. Other debt may be assumed to be worth its book value (the amount shown in the accounts). Alternatively, it is valued in line with the company’s traded debt (for example, with the same risk premium as the most similar traded debt).

Equity can then be assumed to be worth EV less the value of the debt.

The first advantage of EV/EBITDA is that it is not affected by the capital structure of a company, in accordance with capital structure irrelevance. This is something that it shares with EV/EBIT and EV/EBITA

Consider what happens if a company issues shares and uses the money it raises to pay off its debt. This usually means that the EPS falls and the PE looks higher (i.e. the shares look more expensive). The EV/EBITDA should be unchanged. What the “before” and “after” cases here show is that it allows fair comparison of companies with different capital structures.

EV/EBITDA also strips out the effect of depreciation and amortisation. These are non-cash items, and it is ultimately cash flows that matter to investors.

When using EV/EBITDA it is important to ensure that both the EV and the EBITDA used are calculated for the same business. If a company has subsidiaries that are not fully owned, the P & L shows the full amount of profits from but is adjusted lower down by subtracting minority interests. So the EBITDA calculated by starting from company’s operating profits will be the EBITDA for the group, not the company. There are two common ways of adjusting for this:

• Adjust the EV by adding the value of the shares of subsidiaries not owned by the company. The end result is an EV/EBITDA for the group. This becomes complicated if there are a lot of subsidiaries.
• Include only the proportion of EBITDA in a subsidiary that belongs to the company. So if the company has a 75% stake in a subsidiary, only include 75% of the subsidiary’s EBITDA in your calculation. This is simple for companies (such as many telecoms companies) that disclose proportionate EBITDA. Otherwise, it can become difficult if the subsidiaries’ results are not separately available. It also needs the corresponding adjustment to EV. In the example above, only 75% of the subsidiary’s debt would be included in the group EV.

Given these complications, a sum of parts valuation may be considered as an alternative for complex groups. EV/EBITDA could still be used to value each individual part of the group.

EV/EBITDA is usually inappropriate for comparisons of companies in different industries, as their capital expenditure requirements are different. Ideally one would substitute EBITDA minus maintenance capex (capital expenditure required if the business does not expand) for EBITDA. This is difficult. Alternatively, depreciation could be used as an inaccurate but easy proxy for maintenance capex which would mean using EV/EBITA

As with PE it is common to look at EV/EBITDA using forecast profits rather than historical, and similar terminology is then used.