Financial analysts employ several valuation ratios for analysing and identifying over- and undervalued stocks. Most research reports concentrate on the application of such valuation ratios and say very little about the rudiments.
It is important for small investors to understand the basics of such ratios as these can help them analyse the stocks more effectively.
In the first part of the series on understanding financial ratios, we look at the EV/EBITDA ratio, which is preferred by some analysts over the price to earnings or PE ratio.
HOW TO CALCULATE THE RATIO
This ratio has two components: EV and EBITDA. EV, or enterprise value, is calculated by adding the market value of equity and debt, and subtracting the cash holding as shown in the firm’s book of accounts. It gives the cost of acquiring business, as the buyer needs to pay the market value of equity or market capitalisation while purchasing the company. However, the cash with the firm acts as a cushion for the buyer and needs to be deducted.
The value of debt must also be included while estimating the acquisition cost since the interest cost on debt can affect the firm’s future cash flow and the principal is repayable on maturity.
The other part of the metric is the EBITDA, which is also known as the operating profit. EBITDA is the earning before interest cost, tax, depreciation and amortisation, and appears in the firm’s income statement. The other way of arriving at EBITDA is by adding depreciation, interest cost and tax to the net earning.
Comparing the firm’s performance based on net earning leads to a bias due to differences in accounting policies and capital structures. This is because some firms may charge depreciation on an accelerated basis, which leads to high depreciation costs in the initial years.
In addition, some firms have a high debt in their capital structure leading to high interest costs. Such depreciation and interest costs ultimately depress the net earnings. EBITDA discards such difficulties due to varying depreciation policies and debt-equity mix. This measure of earning is also sometimes used as a proxy for cash flow as it adds the non-cash expenditure (depreciation).
HOW IT DIFFERS FROM PE RATIO
The PE ratio measures the money that investors are willing to pay for every rupee a company earns. It is a metric used for valuing the firm’s equity as it takes into account the residual earning available to equity shareholders.
Though widely used, PE ratio has its limitations as it cannot be used for valuing lossmaking companies and fails to overcome the distortions caused by different accounting policies and capital structures.
The EV/EBITDA ratio is better as it values the worth of the entire company. PE ratio gives the equity multiple, whereas EV/EBITDA gives the firm multiple. The latter is based on the notion of most successful investors, who propose that equity investing is not just buying/selling shares, but buying/selling the business.
WHAT THE RATIO MEANS
The division of EV by EBITDA gives a good measure of value. It estimates the number of years in which the business will repay its acquisition cost to the buyer through its earnings. For example, if one is interested in buying a firm at an EV of Rs 1,000 crore and its annual earning (EBITDA) is Rs 200 crore, the firm will repay its entire acquisition cost to the buyer in cash in just five years.
Generally, the lower the ratio, the better it is. The ratio helps determine the true earning potential of the business. It is ideal for valuing telecommunication and cement & steel companies as these carry a high debt in their balance sheets and have high gestation periods.
The ratio proves a great tool for valuing companies that are making losses at the net earning level, but are profitable at the EBITDA level. However, the ratio is harder to calculate as it requires several adjustments in the net income.
Also, EV value is not readily available and has to be derived from the firm’s financial statements. Estimating the true market value of debt is also not easy as it is influenced by changes in interest rates.
Companies with EV/EBITDA less than that of industry
