EV/EBITDA

The price-to-earnings ratio values the equity against the profit left for shareholders. It therefore says nothing useful about two companies that run the same business but carry different amounts of debt.

EV/EBITDA fixes that by moving both halves up a level. The numerator, enterprise value, is what it would cost to acquire the whole business — equity and debt together, net of the cash that comes with it. The denominator, EBITDA, is the cash profit available to all the fund providers, equity and debt holders alike.

Both sides now describe the same object. That is why an analyst comparing companies with different capital structures reaches for this multiple rather than P/E.

Building the numerator. The workbook gives enterprise value as:

Market capitalisation of equity + Market value of debt - Excess cash and cash equivalents.

Cash is deducted for a reason the workbook states plainly: no entity would be interested in paying cash to acquire cash. Buy a company with Rs 500 crore sitting in the bank and you get that Rs 500 crore back on day one.

EV can be read two ways — as how much capital is actually committed in the revenue-generating enterprise, or as how much cash an acquirer would need to buy the target.

Building the denominator. The natural whole-firm earnings measure is EBIT, since it is struck before interest and so belongs to debt and equity holders together. But EBIT is influenced by the accrual mechanics of the accounting system, so analysts adjust towards a cash-based measure by adding back depreciation and amortisation — giving EBITDA.

Where it earns its keep. The workbook is specific: EV/EBITDA is extremely useful in valuing firms which are highly capital intensive and are not yet making book profits at the PAT level or even at the EBIT level, but which are in surplus at the EBITDA level. A company with no earnings has no P/E at all; it still has an EV/EBITDA.

The same numerator supports the EBIT/EV multiple, and EV/Sales, which the workbook prefers to Price/Sales because it takes the company's debt into account.

Enterprise Value = Market capitalisation of equity
                 + Market value of debt
                 - Excess cash and cash equivalents

EV/EBITDA        = Enterprise Value / EBITDA

Two road-infrastructure companies, identical operations, different balance sheets.

On P/E, Beta looks marginally cheaper. On EV/EBITDA it is marginally dearer — and EV/EBITDA is telling the truth, because Beta's lower market capitalisation is not cheapness, it is Rs 1,600 crore of debt that an acquirer would have to assume.

Now the case the workbook singles out. Gamma Infra has just commissioned its assets:

EBITDA                    Rs  460 crore
less Depreciation         Rs  520 crore
EBIT                      Rs  (60) crore    -> negative
less Interest             Rs  240 crore
Profit after tax          Rs (300) crore    -> negative

Market cap Rs 900 cr + debt Rs 2,600 cr - cash Rs 100 cr = EV Rs 3,400 crore

P/E          = not meaningful, there are no earnings
EV/EBIT      = not meaningful, EBIT is negative
EV/EBITDA    = 3,400 / 460 = 7.4x

Two of the three multiples have failed. The third still values the company — because at the gross level, in terms of cash available to the fund providers, Gamma is in surplus.

Chapter 8 (Investing in Stocks), section 8.5.5.6 on the EBIT/EV and EV/EBITDA ratios, with EV/Sales at 8.5.5.7 and EVA and MVA just before at 8.5.5.5. Expect to be asked to construct enterprise value from its three components, to say why cash is deducted, and to identify the situation in which EV/EBITDA works and P/E does not.

• Subtract excess cash, do not add it. An acquirer is not paying for cash it will immediately own.
• Pair like with like. EV goes with EBITDA or EBIT; market capitalisation goes with profit after tax. Mixing them — market cap over EBITDA, or EV over PAT — produces a number that means nothing.
• Use the market value of debt in EV, as the workbook's definition says, not the book value, where the two differ.
• A lower EV/EBITDA is not automatically cheaper. Capital intensity, growth and the size of the depreciation charge all differ; the multiple is comparative within an industry.
• EBITDA flatters a heavily indebted, heavily capitalised firm — the very firms this multiple is recommended for. The depreciation added back is real, and so is the interest.
• EV/Sales is preferred to Price/Sales for the same reason EV/EBITDA is preferred to P/E: it accounts for debt. The workbook makes this comparison explicitly.
• EBIT/EV is the inverted cousin, quoted as a yield rather than a multiple. Do not read a low EBIT/EV as a low EV/EBIT.