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What does an EV/Ebitda multiple mean?

What does an EV/Ebitda multiple mean?
October 25, 2018
What does an EV/Ebitda multiple mean?

Last month, Michael Mauboussin, a highly respected academic, bestselling financial author and director of research at BlueMountain Capital Management, published an extremely insightful paper on how best to understand and use the ratio. The paper, prosaically titled: 'What Does an EV/Ebitda Multiple Mean?', warns, “a naïve use of EV/Ebitda leads to valuation mistakes”.

EV adds on to a company’s market cap the value attributed to non-equity claims on earnings; principally the claims of debtholders represented by net debt. This is done to value the whole enterprise rather than just the portion represented by shares (market cap).

EV is an appropriate measure of company value to compare with Ebitda because just as it puts a value on the interests of all claimholders, Ebitda represents earnings that can be distributed to all claimholders. This is because Ebitda is calculated by adding back a company’s net interest expenses (interest being the 'i' in Ebitda).

Significantly, as well as adding back interest, Ebitda also adds back depreciation and amortisation (the 'da' in Ebitda). Depreciation and amortisation are charged against revenues to reflect past investments that have been made to get a business to its current level of sales and profits. The exclusion of 'da' is the central bugbear of many of the EV/Ebitda ratio’s most vocal detractors. Tax is also ignored by Ebitda.

Mr Mauboussin cites evidence that suggests “after bursting onto the valuation scene in the late 1980s” EV/Ebitda has become investors’ second most used valuation measure after the ubiquitous price/earnings (PE) ratio. He lists three key attributes of the ratio that help explain the growth in popularity: (1) “it’s a broad measure of cash flow and indicates the capacity to invest and service debt”; (2) “it can be relevant for companies losing money because Ebitda is often positive even when earnings are negative”; (3) “Ebitda appears more applicable for companies that seek to minimise taxes by adding debt.”

All good so far, but there are several issues faced by investors that use EV/Ebitda. Aside from the creative adjustments companies and analysts often make to flatter Ebitda, Mr Mauboussin highlights three other key pitfalls: (1) “The potential danger in using Ebitda is that [by ignoring depreciation and amortisation] it understates the capital intensity of the business. As a consequence, Ebitda overstates the amount of cash a company can distribute while running the operations appropriately”; (2) “multiples, including EV/Ebitda do not explicitly reflect risk... Operational leverage, the percentage change in operating profit as a function of the percentage change in sales, is a suitable measure of business risk”; 3) “Two companies with the same Ebitda and capital structures may pay taxes at dissimilar rates. As a result, the EV/Ebitda multiples will be justifiably different.”

When using valuation metrics, a key consideration of what rating is justified comes down to the value a company can create by investing in growth. This is where the nuances of using EV/Ebitda can really be seen when compared with the more commonly used PE ratio. Of key importance in understanding whether investment is worthwhile – assuming suitable investment opportunities exist – is correctly identifying the spread between return on invested capital (ROIC) and the weighted average cost of capital (WACC). As Mr Mauboussin starkly puts it: “If a company is investing at a rate below the cost of capital, growth is bad. The faster it grows, the more wealth it destroys.” Mr Mauboussin illustrates this point with the matrix reproduced below, which shows the justified PE for companies with different growth rates and different ROICs, assuming all have a WACC of 8 per cent and growth forecast over 15 years.

Earnings growthReturn on invested capital
 4%8%16%24%
4%7.112.515.216.1
6%3.312.517.118.6
8%NM12.519.421.8
10%NM12.522.425.7

Source: BlueMountain Capital Management

While Mr Mauboussin’s empirical work finds this theoretical relationship (higher returns and higher growth lead to a higher valuation) holds broadly true for the EV/Ebitda ratio, too, when it comes to examining the justified EV/Ebitda for individual companies, there are extra dimensions to consider.

The amount of debt used to finance a business is significant because it affects the cost of capital. It also increases risk. The other issue is the relative size of a company’s depreciation and amortisation charge (DA), which gives an indication of how capital-hungry its operations may be – arguably the central gripe of Ebitda haters. The significance of DA can be measured by dividing Ebitda by Ebit, to calculate a deprecation factor. All other things being equal, the higher the depreciation factor, the lower the justified EV/Ebitda valuation.

To illustrate this, Mr Mauboussin models justified EV/Ebitda valuations for companies with a constant debt-to-total capital of 20 per cent, and a cost of capital of 7.2 per cent, but with three different depreciation factors of 1.2, 1.5 and 1.8. For example, based on the model’s assumptions, companies with a ROIC of 16 per cent and annual growth of 8 per cent with the respective depreciation factors justify EV/Ebitda multiples of 14.3, 11.5 and 9.5. These are big justified valuation differences that are not reflected in the bald Ebitda number.

The key lesson for investors from Mr Mauboussin’s paper, which is well worth a read in full, is to know what is and isn’t being looked at when using EV/Ebitda. While blind use of the ratio can be dangerous, using it with an understanding of its limitations can provide a valuable way to unearth opportunities that other valuation metrics would not highlight. And while those that regard the ratio’s limitations as irredeemable shortcomings may still prosper, they deprive themselves of a potentially useful valuation tool.

 

Further Reading:

What Does an EV/EBITDA Multiple Mean?, Michael Mauboussin, Sep 2018