What Is the EBIT/EV Multiple?
The EBIT/EV multiple, shorthand for earnings before interest and taxes (EBIT) divided by enterprise value (EV), is a financial ratio used to measure a company's "earnings yield."
The concept of the EBIT/EV multiple as a proxy for earnings yield and value was introduced by Joel Greenblatt, a noteworthy value investor and professor at Columbia Business School.
Key Takeaways
- Investors and analysts use the EBIT/EV multiple to understand how earnings yield translates into a company's value.
- The higher the EBIT/EV multiple, the better for the investor as this indicates the company has low debt levels and higher amounts of cash.
- The EBIT/EV multiple allows investors to effectively compare earnings yields between companies with different debt levels and tax rates, among other things.
Understanding the EBIT/EV Multiple
Enterprise value (EV) is a measure used to value a company. Investors often use EV when comparing companies against one another for possible investment because EV provides a clearer picture of the real value of a company as opposed to simply considering market capitalization.
EV is an important component of several ratios investors can use to compare companies, such as the EBIT/EV multiple and EV/Sales. The EV of a business can be calculated using the following formula:
EV = Equity Market Capitalization + Total Debt − Cash (& Cash Equivalents)
The EV result shows how much money would be needed to buy the whole company. Some EV calculations include the addition of minority interest and preferred stock. However, for the vast majority of companies, minority interest and preferred stock in the capital structure is uncommon. Thus, EV is generally calculated without them.
EBIT/EV is supposed to be an earnings yield, so the higher the multiple, the better for an investor. There is an implicit bias toward companies with lower levels of debt and higher amounts of cash. A company with a leveraged balance sheet, all else being equal, is riskier than a company with less leverage. The company with modest amounts of debt and/or greater cash holdings will have a smaller EV, which would produce a higher earnings yield.
Benefits of the EBIT/EV Multiple
The EBIT/EV ratio can provide a better comparison than more conventional profitability ratios, such as return on equity (ROE) or return on invested capital (ROIC). While the EBIT/EV ratio is not commonly used, it does have a couple of key advantages in comparing companies.
First, employing EBIT as a measure of profitability, as opposed to net income (NI), eliminates the potentially distorting effects of differences in tax rates. Second, using EBIT/EV normalizes for effects of different capital structures.
Greenblatt states that EBIT "allows us to put companies with different levels of debt and different tax rates on an equal footing when comparing earnings yields." In his eyes, EV is more appropriate as the denominator because it takes into account the value of debt, as well as the market capitalization.
A downside to the EBIT/EV ratio is that it does not normalize for depreciation and amortization costs. Thus, there are still potential distorting effects when companies use different methods of accounting for fixed assets.
Example of the EBIT/EV Multiple
Say Company X has:
- EBIT of $3.5 billion;
- A market capitalization of $40 billion;
- $7 billion in debt; and
- $1.5 billion in cash.
Company Z has:
- EBIT of $1.3 billion;
- A market cap of $18 billion;
- $12 billion in debt; and
- $0.6 billion in cash.
EBIT/EV for Company X would be approximately 7.7%, while the earnings yield for Company Z would be approximately 4.4%. Company X's earnings yield is superior not only because it has greater EBIT, but also because it has lower leverage.
When it comes to financial analysis and ratios like the EBIT/EV multiple, diving into the world of company valuation and financial metrics is like navigating a landscape of numbers that unveil a company's true worth. The EBIT/EV multiple, a ratio that encapsulates the earnings yield, speaks volumes about a company's financial health and potential.
The EBIT/EV multiple, credited to Joel Greenblatt, a luminary in value investing and a Columbia Business School professor, signifies the division of Earnings Before Interest and Taxes (EBIT) by Enterprise Value (EV). This ratio essentially unveils the company's earnings yield, allowing investors to gauge its value against its market capitalization.
Enterprise Value (EV) is a comprehensive indicator, superior to mere market capitalization, as it considers the true value of a company by including debt and cash equivalents. The formula to calculate EV involves adding Equity Market Capitalization, Total Debt, and then subtracting Cash (& Cash Equivalents).
The power of the EBIT/EV multiple lies in its ability to level the playing field among companies with varying debt levels and tax rates. A higher EBIT/EV multiple is advantageous for investors, signaling lower debt levels and more substantial cash reserves within a company. This ratio enables effective comparisons between companies despite differences in their financial structures.
But like any financial metric, the EBIT/EV multiple has its nuances. While it normalizes for differences in tax rates and capital structures, it does not account for depreciation and amortization costs. This can create distortions in the comparison, particularly when companies use different accounting methods for fixed assets.
To exemplify its application, consider two hypothetical companies, X and Z. Company X with higher EBIT and lower leverage boasts an EBIT/EV of approximately 7.7%, whereas Company Z, with lower EBIT and higher leverage, shows an earnings yield of around 4.4%. Here, Company X's superior earnings yield isn't just due to higher EBIT but also its lower leverage, showcasing the practical significance of the EBIT/EV multiple in assessing investment potential.
In essence, the EBIT/EV multiple serves as a potent tool for investors and analysts, offering a lens to discern a company's true value and earnings potential beyond superficial market capitalization, making it an indispensable metric in the realm of financial analysis and investment decision-making.
