Understanding and practical interpretation of EV/EBITDA
Knowing the difference between EV (Enterprise Value) and equity value is critically important for the use of EV/EBITDA. Suppose there are Flat A and B with the same price in London as shown in the figure below.
Flat A and B with the same price (to explain the meaning of EV/EBITDA)
Mr X and Ms Y purchased A and B respectively at the same price as above. All of them took over all the existing owners’ mortgage loans. In summary, Mr X took over the existing loan of £600,000 and purchased flat A with his own capital of £400,000. Ms Y undertook the original loan of £200,000 and bought flat B with her own capital of £800,000.
In that case, how much did X and Y each buy an apartment for? The details of the funds X and Y mobilised are as follows.
The details of the funds Mr X and Ms Y mobilised to buy a flat (to explain the meaning of EV/EBITDA)
The answer is that both X and Y bought them for £1 million. The equity capital of X and Y is £400,000 and £800,000, respectively, but the total price of both flats is £1 million. So, they bought each apartment at the same price.
EV (Enterprise Value)
The concept in the picture above can be applied to companies. Considering the two flats as Company A and Company B, respectively, the EV (enterprise value) of A and B are both £1million. Also, A and B’s equity values, that is, the shareholders’ values are £400,000 and £800,000, respectively. A’s £600,000 of the mortgage loan, and B’s £200,000 are the value attributable to banks, that is, the debtholders’ value.
Reflecting this concept, the relationship between enterprise value and equity value is as follows.
EV (Enterprise Value) = Debtholder’s value + Equityholder’s value
Sometimes, EV and equity value are used without distinction. However, the two values are by no means the same.
EV is the sum of shareholders’ value and debtholders’ value, and equity value refers to shareholders’ value only.
From an M&A perspective, the distinction between EV and equity value becomes more important. From the buyer’s point of view, the amount of acquiring a company is its enterprise value. As in the case of the flats above, the amount paid to previous shareholders is the equity value, and the total acquisition amount is the enterprise value since new owners took over all the debts of each company.
Here, you should consider only financial debts paying interest as liabilities in enterprise value.
You can also consider the EV as the market value of the capital that generates EBITDA. Take a look at the picture below.
Relationship between financial statement items and the values of debtholders and shareholders
EV is the sum of the market value of financial debts and total equity on the balance sheet’s right side. The stakeholders are debtholders and shareholders. By generating revenue with capital from the two stakeholders, the interest is attributed to debtholders, and net income to shareholders. Therefore, you can say that EV generates operating profit, and equity value generates net income.
In the meantime, depreciation and amortisation are the representative expenses that do not incur actual cash outflow. They are the recognition for the cash that has already flowed out for capital expenditures as the expenses. EBITDA refers to the profit obtained by adding this depreciation and amortisation to the operating profit and is used as a profit indicator generated by EV.
You can calculate EBITDA by adding interest, income tax, and depreciation and amortisation to net income. However, the easy way is to add depreciation and amortisation to operating profit directly. Extraordinary gains or losses arising after operating profit are literally not recurring, so you can consider it not to happen in the future.
EBITDA = (Net profit + interest + tax) + depreciation and amortisation
≈ Operating profit + depreciation and amortisation
EV/EBITDA is a multiple of EV divided by EBITDA and is defined as follows.
There are two reasons for deducting cash and equivalents from the EV.
First, EBITDA includes interest expenses but not interest income generated from excess cash. So the EV/EBITDA multiple will be overvalued unless you deduct them from the EV.
Second, you should consider only the remaining debts after repaying some of the total debts with the cash assets. The concept could be more straightforward from the perspective of a company acquirer.
- Assume that you acquired Firm A with financial debts of £2 million by paying £1 million for the total equity. In that case, we say that you bought A for £3 million.
- Let’s add one assumption. Firm A holds £1 million in cash with all other situations equal to case 1. In that case, you can repay the financial debts of £1 million out of the total debt with the cash the firm holds after you took over Firm A at £1 million. Eventually, you can say that you acquired Firm A at £2 million.
The reasons why EV/EBITDA is useful are as follows.
First, EBITDA may be in the black even for companies with a deficit in the net or operating profit. Therefore, the EV/EBITDA valuation can be applicable to more companies.
Second, accounting principles do not affect EBITDA even though each company recognises depreciation on a different accounting basis because depreciation and amortisation are added back to operating income.
Third, net profit is affected by the borrowings since it is the profit after interests are all paid. However, EBITDA is the profit before interests are paid, so it is not affected by the leverage.
For those reasons, EV/EBITDA can be more useful for businesses with long-term capital expenditures such as telecommunications companies, aviation, ports, and roads.
 Precisely speaking, it refers to the net debts that cash and equivalent are deducted from the total debts. This would be explained in another blog.