Why is EV/EBIDTA most preferred valuation parameter
The EV/EBITDA multiple has two components - numerator is EV or enterprise value. In layman‘s language, it is the price of the firm. EV is arrived at as market cap plus debt raised, preference share capital minus cash and cash equivalents.
December 17, 2012 / 09:54 IST
In markets, where most financial parameters are dynamic, to value a company can be a daunting task. Some say valuing a company on price to earnings multiple is a good way to gauge whether a company is expensive or economical.
There are those who suggest price to book value - the cash a company can generate by selling off its assets - as the right financial parameter to arrive at a value of a company.And there are many who recommend looking at debts of a company to ensure that the value of a company is captured well.However, each of these financial parameters, when considered in isolation, fails to capture a few aspects of a company’s balance sheet.This is the reason why many analysts and fund managers use Enterprise Value to Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) as a financial parameter to gauge the value of a company, especially while considering its acquisition.So, what are the reasons that make this financial parameter the most preferred one in gauging the value of a company?The BasicsFor those who access research reports daily, the possibility of coming across the financial parameter EV/EBITDA is quite high.Many brokerage reports end with analysts recommending a stock citing the reason that the stock quotes at a 30% discount to the EV/EBITDA multiple of the industry average. However, there are many retail investors who don’t pay heed to this multiple considering it too technical and move on to see the upside. After all, it is the price of the scrip that matters the most. However it is better to understand how one arrives at the multiple, as it would help investors in understanding the valuation of a business better before buying or selling it.The EV/EBITDA multiple has two components – numerator is EV or enterprise value. In layman’s language, it is the price of the firm. EV is arrived at as market cap plus debt raised, preference share capital minus cash and cash equivalents.To put it simply, it is the price you will pay if you want full control of the firm. By paying off all shareholders and bondholders you can enjoy full control of the firm and quite understandably you can enjoy the cash the way you want. Hence, EV consists of all types of capital but deducts cash and cash equivalents.The denominator is EBITDA. It means earnings before interest, taxes, depreciation and amortization. In a profit and loss statement, an investor can simply deduct cost of goods sold from net sales. Net sales mean gross sales minus sales tax or taxes billed to the customer. In plains terms, EBITDA represents operating profit. It talks about the profit a company makes by being in the business. It does not take into account various factors like the cost of financing, rate of tax and non-cash expenditure such as depreciation.Hence, EV/EBITDA, in essence, captures what an acquiring company would have to take on its books and how it would gain in terms of cash and other sector dynamics of the company that is targeted for the purpose of acquisition.The ReasonsEV/EBITDA is a preferred valuation technique used by investment bankers and business analysts to compare one business with another. This tool works better to compare companies with varying capital structure with each other. It helps analysts in keeping away the influence arising out of capital structures.For example, a company with no debt will report a high net profit margin compared to a company with huge debt on the balance sheet. But a focus on EBITDA ensures that the analyst has gauged the operational efficiency of the company.EV on the other hand brings in a more realistic measure of a company’s intrinsic value. Market capitalization of the equity shares bring in the market perception of the company.Typically well-managed companies enjoy higher multiples in public markets than those companies with poor managements.In the short term the market capitalization of a firm might go up or down due to some temporary events or sentiments in the markets. In case of debt, the market looks at the market value of debt, if the debt is listed on the exchanges.For example, if the bonds issued by a firm is listed on the stock exchange and market value of these bonds is quoting below the face value, then the market value will be taken and not the face value.Also, if preference shares of a company are traded on the exchange then the market value is considered. If such instruments issued by the bank are not traded on the stock exchanges, then the face value or historical value is taken into account along with the accrued interest on such instruments. VariantsEven though EV/EBITDA is a widely used financial parameter to gauge the value of a company, there are a few variants of this to arrive at a value of a company. These variants are used when companies have negative operating profits and are also incurring major losses. Many a time companies in sectors such as airlines, infrastructure and other capital-intensive businesses which squeeze more revenues due to high debt, the EV/Sales financial parameter comes handy.EV, however, has got its own disadvantages too. It originates in public markets - market capitalization of a firm is applicable only when the shares are listed and there is enough free-float in the market. In an unlisted company the shares quote at face value.In case of a public limited company which does not have much float, share prices can be manipulated. The EV of such a company can also be influenced. In such cases, a combination of financial parameters is taken into consideration. These are debt to equity, replacement cost value, working capital management and cash flow from operations.Source: Nirmal Bang's Beyond MarketClick here to read the full magazineDisclaimer: The views and investment tips expressed by investment experts/broking houses/rating agencies on moneycontrol.com are their own, and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions. Discover the latest Business News, Sensex, and Nifty updates. Obtain Personal Finance insights, tax queries, and expert opinions on Moneycontrol or download the Moneycontrol App to stay updated!
