The good and bad about the EBITDA/EV ratio that Warren Buffett hates.
Equity analyst and investors use the disclosed business information to determine the value of a firm. The EBITDA has been identified as one of the metrics that can measure the value of the firm. The EBITDA measures the profitability of a company before noncore expenses, and no cash charges are made. The EBITDA is one of the metrics that have been misused by companies to try and make a company look attractive. Some companies will take advantage of the EBITDA since it does not exclude expenses such as depreciation and amortization. They use the EBITDA to mislead investors into concluding that a company is financially healthy. EBITDA is an easy metric to manipulate.
If a company uses fraudulent accounting practices, it can exaggerate revenues and interest. There have been cases of companies managing their accounting records to get a high EBITDA. When some companies realize that the EBITDA is facing a downward trend, they have changed the expenses into assets and depreciated these assets to keep the EBITDA at a high level. Investors and equity analysts have improved on EBITDA to avoid getting misleading information. One of the metrics is EV/EBITDA which is an improvement of the EBITDA. It compares the EBITDA with the enterprise value making it a good metric valuation. The EBITDA/EV is considered as a valid measuring metric because it accounts for all the cash flows of the business. It takes off the weaknesses of using EBITDA because it measures the real cash flows of a company.
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One of the benefits of using the EBITDA/EV ratio is that it makes adjustments that allow investors to identify the real cash flow issues of a company. The EBITDA can easily be manipulated using accounting policies of an organization. However, the enterprise value includes various liabilities of a business that is key to investors. Comparing the EBITDA to the EV can indicate if a business has cash flow issues.
The EBITDA/EV ratio is an effective metric during mergers and acquisition. M& A have become an important part of the global environment. Companies moving to international markets are using M&A to establish themselves in new markets. A good example of M& A is the ChemChina and Syngenta deal which has been identified as one of the largest acquisition in history. After numerous meetings and negotiations, Syngenta accepted $43 billion. This made it the largest foreign acquisition by a Chinese company. In this type of a large purchase, ChemChina had to produce a valuation of Syngenta before buying the company and negotiating on the sell out the price. The EBITDA/EV is a good assessment method during this type of an acquisition that involves large firms. Though it is not used alone and other methods of valuation are applied it is one of the widest valuation during M&A.
The EBITDA/EV ratio gives a clear picture of the value of the business given the cash flows hence it is a good valuation metric in showing the real value of the business.
The EBITDA/EV ratio allows investors to compare organizations operating in different countries. Making a comparison of a firm in the United Kingdom to a company in the United States is difficult. The two organizations use different accounting standards. Though countries are working hard to harmonize accounting standards, different countries still use different accounting practices. Countries are guided by their legal framework and the set accounting standards when preparing their final financial records. As a result, it is not easy to compare businesses in different countries since the companies may have used different methods when valuing some important factors such depreciation, and stock. EBITDA/EV offers investors a good metric to make comparisons. It excludes various items such as depreciation, taxes, and amortization. An investor can use this metric to compare companies that use different depreciation methods.
The EBITDA/EV ratio is a sufficient metric valuation because it is less volatile. The EBITDA/EV is considered to be stable compared to other assessment methods. The EBITDA excludes some items that can cause the metric to be unstable such as taxes, and interest. It is considered to be more stable that the earnings. On the other hand, EV is considered to be more stable than equity value. A ratio of the EBITDA and EV provides investors and equity analyst with a stable valuation of a company.
The EBITDA/EV has certain drawbacks. The EBITDA/EV ratio eliminates some valuable items such as taxes and depreciation hence it fails to take account of the working capital. The EBITDA has been criticized for eliminating taxes. The logic behind tax elimination is that it is out of the control of a business and it can change in any given year. However, most businesses have stable tax rates. Including taxes in the valuation of the company is important because it will show investors some cash flows that are available to investors. It allows investors to have a clear picture of the real cash flows of the business. The second elimination that EBITDA makes is the depreciation and amortization. When these two items are eliminated, the cost of capital is not accounted for. As a result, the growth of the company is not considered for. In manufacturing companies, it is critical to indicate the level of capital growth. The EBITDA/EV ratio is not a useful measure in certain industries because it fails to measure the capital intensity.
The EBITDA/EV ratio - Final Points
The EBITDA/EV ratio like any other metric valuation has its advantages and disadvantages. Investors should form a habit of using more than one metric valuation. Using different metric valuation ensures that an investor deals with the weakness of other metric valuation. The EBITDA/EV is a good metric valuation in mergers and acquisition. It can be used to evaluate the value of a company during M&A. Additionally, it is a good measure when comparing different companies which are subjected to different accounting standards. However, the EBITDA/EV has certain disadvantages it gets rid of important factors in a business such as taxes and depreciation. To cater for disadvantages of the EBITDA/EV, investors can use other methods such as FCF.