EV/EBITDA and why its a focus for us
Enterprise value / EBITDA (EV/EBITDA) is a valuation multiple we focus on when valuing a range of businesses.
The Enterprise Value (EV) is the combined value of equity and net debt. Earnings Before Interest, Tax, Depreciation and Amortisation (EBITDA) is a measure of earnings before the cost of debt and non-cash charges.
The EV/EBITDA multiple is "capital structure-neutral" - that means it takes into account debt and equity so companies with different levels of debt can be compared. The multiple has also been described as the "Acquirer's Multiple" because when a corporate or financial buyer seeks to buy 100% of a business they will look at the capital structure-neutral valuation with a view to applying their own mix of equity and debt to the cost of acquisition.
Analysis focused on EV/EBITDA should also take into consideration the capital expenditure requirements of the company. EV/EBIT is an alternative measure that considers earnings after the accounting charges for Depreciation and Amortisation (DA) as these charges are meant to be a proxy for ongoing capital expenditure. However, particularly with small and emerging companies, we often see a wide divergence between accounting DA charges and actual cash capital expenditure demands. We also see DA as sources of distortion when trying to assess underling earnings.
Sometimes businesses that have significant debt positions can look attractive based on Price / Earnings (P/E) if the interest cost is relatively low - but if the level of debt is unsustainable, the company may need to pay it down by issuing new shares in future.
There are some businesses for which EV/EBITDA is not an appropriate measure, including banks and alternative lenders for whom debt is effectively the commodity they deal in - these businesses are better assessed through the prism of Price / Earnings (P/E) and Price / Book multiples.
Research on US equity valuations over 40 years by Wesley Gray and Jack Vogel - "Analyzing Valuation Measures: A Performance Horse-Race over the past 40 Years" - highlighted the power of the EV/EBITDA multiple, although they used the inverse (EBITDA/EV). You can read a version of that paper here.