We have a whole series of articles on valuation metrics – you can read them here – General article – PE – PEG – Analysis using free cash flow – and  Looking at price to book value.

The enterprise value is computed by adding debt, minority interests and any preferred shares to market capitalization and deducting cash. (including cash equivalents). This arrives at a figure for the total value of the enterprise and is regarded by many value investors as a more realistic measure of the value of the enterprise than the market capitalization. After all, it is the whole enterprise including all its assets that engages in business operations and earns profits, and anyone looking to take over the whole company would have to take on the debt as well as purchase the equity. Enterprise value therefore looks at the value of the assets of the enterprise regardless of the way the business operations are financed.

EBITDA is a suitable measure of profit to take into consideration in relation to enterprise value. The earnings before interest, tax, depreciation and amortization (EBITDA) represent the profits earned by the enterprise regardless of the particular form of financing used. The interest paid on debt is not deducted and of course dividend payments on equity are not taken into consideration in arriving at this earnings figure. The non-cash items depreciation and amortization are added back and taxes are left out of the calculation.  The EBITDA is therefore one way of looking at  the funds generated by the business operations out of which the business will pay interest, dividends and taxation in addition to other necessary payments such as amount required to repair or replace fixed assets.

One reason why analyzing EV/EBITDA may appeal to value investors can be found by remembering the maxim of Warren Buffett that the investor when buying shares is actually purchasing a piece of the whole enterprise rather than just buying a financial instrument that yields a dividend stream. Assessing the value of an investment is therefore a question of assessing the company into which one is investing. EV/EBITDA gives an idea of how the enterprise is currently valued in relation to the funds generated annually.

This metric is a method for comparing different companies in the same industry and identifying those that could be undervalued. As the ratio does not take into account the levels of debt to equity in a company it can be used to compare companies whatever their capital structure. Some other metrics such as the price earnings ratio that looks at the share price in relation to earnings may give a misleading impression because companies carrying high levels of debt will tend to have a lower price earnings ratio resulting from the way they are financed.

EV/EBITDA may also be used to compare different companies regardless of how asset intensive a company may be. As EBITDA leaves out of the equation depreciation and amortization the result is not affected by high levels of depreciation charged by capital intensive enterprises. As the sums spent on renewing assets are not taken into consideration the measure is appropriate for comparing companies with different asset levels.

A low result for EV/EBITDA could be a sign of an undervalued company that is ripe for investment. This would only be a first indicator and any sensible value investor would not take a decision until performing further research, looking at other metrics, reading the annual report thoroughly and forming an opinion of the management. As with the use of any metric the investor should look for the reasons why the enterprise is apparently undervalued and test the result by applying other metrics as appropriate.

A weakness of EV/EBITDA comes from the question of what precisely EBITDA is measuring. This figure should not be mistaken for a measure of cash flow because it does not take into account the necessary capital expenditure of an enterprise year on year. Although EBITDA may be useful in short term calculations to see what funds are available to cover interest payments it is not a substitute for a longer term figure for cash generated that would take into account all necessary expenditures including capital expenditure. EBITDA may therefore give a misleadingly high figure that could make a corporation look undervalued when measured using EV/EBITDA.

From a value investor’s point of view, using EBITDA excludes from the equation some of the benefits of good management. For example, a low interest charge on debts may be a result of good planning and negotiation by management and a low tax figure could reflect good long term tax planning, both features of a well managed company. By excluding these from the equation EV/EBITDA is ignoring some signals that may point to good management. The value investor must investigate these signals by other means such as applying alternative metrics or studying corporate business strategy and other evidence from the annual report.