There are several valuation ratios used to analyse stocks. The most commonly used is the price to earnings (PE) ratio, which measures the amount of money investors are willing to pay for every rupee a company earns. However, it cannot be used for valuing loss-making companies. It also fails to overcome the distortions caused due to different accounting practices and capital structures. The EV/EBITDA ratio is a more reliable alternative as it calculates the worth of the entire company. Its basis is that equity investing is more of buying or selling the entire firm.
The ratio has two components: EV and EBITDA. The EV or enterprise value is calculated by adding the market value of equity and debt and subtracting the amount of cash in the firm’s books of accounts. It gives the cost of acquiring the business as the buyer needs to pay the market value of the company. The cash available with the firm acts as a cushion for the buyer and, therefore, needs to be subtracted.
EBITDA (earnings before interest costs, taxes, depreciation and amortisation) is also known as operating profit and appears in the firm’s income statement. It can also be calculated by adding depreciation, interest costs and taxes to the net earnings. Comparing a firm’s performance based only on net earnings leads to biased opinion due to different accounting practices and capital structures. Depreciation and interest costs depress net earnings. EBITDA steers clear of anomalies associated with depreciation policies and debt-equity mix.
How To Choose
Dividing EV by EBITDA gives a good measure of value. It estimates the number of years in which the business will repay its entire acquisition cost to the buyer through its earnings. For example, if one is interested in buying a firm at an EV or acquisition cost of Rs 1,000 and its annual earning (EBITDA) is Rs 250; the firm will repay the buyer (in cash) in just four years.
Generally, the lower the ratio, the better it is as less time will be required by the company to repay the amount put in by the investor. EV/EBITDA helps in determining the true earning potential of the business. It is ideal for valuing telecommunication, cement and steel firms as these carry high debt in their balance sheets and are prone to long gestation periods. The ratio proves a great tool for valuing companies that are making losses at the net earnings level but are profitable at EBITDA level.
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