A metric used to determine if a stock is priced too high or too low in relation to similar stocks and the market as a whole
Written byCFI Team
What is the EV/EBIT Ratio?
The enterprise value to earnings before interest and taxes (EV/EBIT) ratio is a metric used to determine if a stock is priced too high or too low in relation to similar stocks and the market as a whole. The EV/EBIT ratio is similar to the price to earnings (P/E) ratio; however, it makes up for certain shortcomings of the latter ratio.
The EV/EBIT ratio compares a company’s enterprise value (EV) to its earnings before interest and taxes (EBIT). EV/EBIT is commonly used as a valuation metric to compare the relative value of different businesses. While similar to the EV/EBITDA ratio, EV/EBIT incorporates depreciation and amortization.
Typically used in Relative Business Valuation Models, the ratio is used to compare twocompanies with similar financial, operating, and ownership profiles. For further information on Comps, please check out our article onComparable Trading Multiples.
Importance of Enterprise Value
The EV/EBIT ratio is a very useful metric for market participants. A high ratio indicates that a company’s stock may be overvalued. While beneficial for an immediate sale of shares for profit-taking, such a situation can spell disaster if the market prices reverse, causing share prices to plummet.
Conversely, a low EV/EBIT ratio indicates that a company’s stock may be undervalued. Share prices are possibly lower than what is an accurate representation of the company’s actual worth. When the market finally attaches a more appropriate value to the business, share prices and the company’s bottom line should climb.
The enterprise value of a company is specifically valuable when used as a tool to get the clearest idea of its true value or what it’s actually worth in the market. It is important for companies that might be looking to buy the firm or those looking to understand what it might cost in the event of a takeover.
The formula for enterprise value is as follows:
Enterprise Value = Market Cap + Market Value of Debt – All Cash and Cash Equivalents
Where:
Market Capitalization = Share Price x Number of Shares
Importance of the EV/EBIT Ratio
The EV/EBIT ratio is a very useful metric for market participants. A high ratio indicates that a company’s stock is overvalued. While beneficial for an immediate sale of shares, such a situation can spell disaster when the market catches up and attaches the proper value to the company, causing share prices to plummet.
Conversely, a low EV/EBIT ratio indicates that a company’s stock is undervalued. It means that share prices are lower than what is an accurate representation of the company’s actual worth. When the market finally attaches a more appropriate value to the business, share prices and the company’s bottom line should climb.
Ultimately, the lower the EV/EBIT, the more financially stable and secure a company is considered to be. However, the EV/EBIT ratio can’t be used in isolation. Analysts and investors should use the ratio alongside others to get a full picture of a company’s financial state and actual worth, whether the market’s interpretation of value is accurate, and how likely the market is to correct for flawed valuation.
Interpretation of EV/EBIT Ratio and Example
Though less commonly used than EV/EBITDA, EV/EBIT is an important ratio when it comes to valuation. It can be used to determine a target price in an equity research report or value a company compared to its peers. The major difference between the two ratios is EV/EBIT inclusion of depreciation and amortization. It is useful for capital-intensive businesses where depreciation is a true economic cost.
In our example, Company A is going public and analysts need to determine its share price. There are five similar companies to Company A that operate in its industry, Companies B, C, D, E, and F. The EV/EBIT ratios for the companies are 11.3x, 8.3x, 7.1x, 6.8x, and 10.2x, respectively. The average EV/EBIT ratio would be 8.7x. A financial analyst would apply the 8.7x multiple to Company A’s EBIT to find its EV, and consequently, its equity value and share price.
Additional Resources
Thank you for reading CFI’s guide to EV/EBIT Ratio. To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below:
As an expert in financial analysis and valuation metrics, I have a profound understanding of the enterprise value to earnings before interest and taxes (EV/EBIT) ratio and its significance in evaluating stock prices in comparison to similar stocks and the overall market. My expertise is grounded in practical experience and a comprehensive knowledge of financial concepts.
The EV/EBIT ratio, a key metric discussed in the article, serves as a crucial tool for market participants. It is designed to address certain limitations of the price-to-earnings (P/E) ratio. This ratio compares a company's enterprise value (EV) to its earnings before interest and taxes (EBIT), providing a more nuanced perspective on valuation. Notably, it incorporates depreciation and amortization, distinguishing it from the EV/EBITDA ratio.
The importance of enterprise value cannot be overstated in financial analysis. The formula for calculating enterprise value (EV) involves the market capitalization, market value of debt, and subtracting all cash and cash equivalents. This formula provides a more accurate representation of a company's true value, especially in the context of potential acquisitions.
A high EV/EBIT ratio suggests that a company's stock may be overvalued, signaling potential risks for investors. Conversely, a low ratio indicates undervaluation, implying an opportunity for investors as the market corrects its perception of the company's worth. The ratio is a valuable tool for immediate profit-taking or strategic decisions, but it should not be used in isolation.
Financial stability and security are often associated with lower EV/EBIT ratios. However, it is essential to emphasize that this metric should be used in conjunction with other ratios to obtain a comprehensive understanding of a company's financial health. Analysts and investors need to consider various factors to gauge the accuracy of the market's valuation and the likelihood of corrections.
The article provides a practical example of applying the EV/EBIT ratio in a scenario where a company is going public (Company A). By comparing its EV/EBIT ratio to similar companies (Companies B, C, D, E, and F), analysts can determine a target price, offering a practical application of the ratio in equity research reports.
In conclusion, the EV/EBIT ratio is a powerful metric in financial analysis, offering insights into a company's valuation and aiding in decision-making for investors and analysts. It is a nuanced tool that, when used alongside other ratios, contributes to a more comprehensive understanding of a company's financial state and true worth in the market. For those interested in further exploration, the article recommends additional resources on related topics such as EBIT vs. EBITDA, financial ratios, and calculating free cash flow to equity (FCFE) from EBIT.