How Enterprise Value to EBITDA Ratio Can Help Uncover Profitable Stocks

We often discuss the P/E Ratio for comparing the stocks in the same sectors. However, there are other prudent and simple valuation ratios a retail investor can use in selecting the stocks for their investments. In this article, we are going to discuss, one of such ratios. That is EV/EBITDA.

EV/EBITDA is a popular valuation multiple used widely in the equity research. Enterprise Value (EV) is considered an alternative to Market capitalization, while Earnings Before Interest, Tax, Depreciation, and Amortization (EBITDA) is the operating profit made by a company.

Enterprise Value Formula & its importance:

The components of the Enterprise Value are Market Capitalization, Debit and Cash.

The formula of Enterprise Value is Market Capitalization + Debt – Cash.

Let us check an illustration to calculate, a pharmaceuticals LTD.

Thus, if a company is acquiring Pharmaceuticals Limited, then the acquirer will get the Assets and liabilities of the company as well, so theoretically the one has to pay Rs.12,800/- to acquire the company.

EBITDA Formula & its importance:

The components of EBITDA are Earnings, Interest, Tax, Depreciation & Amortization.

The formula of EBITDA is Operating Income + Depreciation & Amortization

Let us check the illustration of the same company we used in the calculation of Enterprise Value (EV)

The operating income considers only the profit achieved from a company’s business operations, while net profit includes the expenses at the accounts level. So, the EBITDA growth of a company mirrors the growth achieved by a business through its core operations.

EV/EBITDA as a Valuation Method:

To arrive at a fair value of a company using the method of EV/EBITDA, the ratio compares the relativity of Enterprise Value to the Operating Income and takes debt and income generated through core operations of the company are taken into consideration.

In the above case, the EV/EBITDA multiple is 15.05

Thus, EV/EBITDA can be used as an alternative to the P/E Ratio because of the added advantage of EV/EBITDA taking debt and earnings from the core operations of the business into account.

The EV/EBITDA will compare the companies from a similar sector, the lower the EV/EBITDA multiple, the better the company.

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