Picking the Right Stocks with EV/EBITDA Ratio

Introduction

Before investing in stocks, it is essential to evaluate the value of that stock. Often, amateur investors get caught up in the stock prices and market capitalisation. However, to get a truly comprehensive idea of how a company is performing, looking at its enterprise value or EV is helpful because it provides a more holistic picture. 

What is Enterprise Value?

Enterprise value (EV) measures a company’s total value, including its short-term and long-term debt. While market capitalisation presents the market value of a company, EV is a measure that helps one understand at what value the company would be taken over if it were to come to that. Including debt and cash balances as part of the valuation provides a more realistic picture of the company’s position. 

A company's EV is calculated by adding its equity or market capitalisation, short-term and long-term debt, and subtracting any cash equivalents.

EV can be a good measure to understand a company’s worth during a merger or acquisition or even to compare companies with different capital structures. 

What is EBITDA?

EBITDA, or earnings before interest, tax, depreciation and amortisation, is a profitability measure used to understand a company’s financial health. It is often used instead of net income. It is a straightforward metric to calculate: add net income, interest, tax, depreciation, and amortisation to arrive at EBITDA. 

What is EV/EBITDA Ratio?

The EV/EBITDA ratio is a valuation multiple used to compare the values of different companies. It can be used to understand whether a company is overvalued or undervalued. You can arrive at the multiple by dividing the company’s enterprise value by its EBITDA. 

Many analysts and financial investors use the EV/EBITDA ratio instead of the P/E ratio to understand the value of a company. However, the EV/EBITDA ratio of companies varies depending on the industry they belong to. In isolation, the ratio has little value. You should compare peers’ EV/EBITDA ratios to understand whether a company is worth investing in. 

How to Use EV/EBITDA to Invest in a Company?

Just like the P/E ratio, the lower the EV/EBITDA ratio, the better it is for a company. If a stock you have selected has a low EV/EBITDA ratio compared to its peers, it is undervalued. Buying it at this stage may give you a valuation advantage. 

If the EV/EBITDA ratio is too high compared to its peers, it seems that the company is overvalued. However, you can’t rely only on one parameter to evaluate a stock.

EV/EBITDA ratio can also be used along with the P/E ratio as the former also considers the company's debt value.

Follow these steps to use this metric to analyse whether a company’s stock is worth investing in: 

1. Identify the industry that the stock you want to analyse belongs to 

2. Find five to 10 comparable companies of same sector.

3. Gather at least three years of financial information for each company that includes key financial ratio.

4. Check the EV/EBITDA ratio and other valuation ratio. 

5. Compare the multiples and see how your company is positioned against its peers. 

Let’s understand this with an example. Following table shows the financial ratio of 5 companies of a same sector.

 The average EV/EBITDA of these companies is 14.

Companies 1 & 2 traded at above-average EV/EBITDA, which may be due to high growth, better ROE and ROCE. ROE is the return on equity capital and can be calculated by dividing the net profit by the company's equity capital. At the same time, ROCE considers total capital instead of equity capital. Based on the above data, companies 1 and 2 could be considered favourites among these. However, one also needs to evaluate other ratios and parameters before investing.

Conclusion 

The EV/EBITDA ratio is a useful measure to understand the right value of a company. However, use this metric alongside other metrics, such as the P/E ratio, to evaluate whether a company is undervalued or overvalued.

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