The Single-Best Metric: EV/EBITDA

Here’s a post for new investors—and perhaps a refresher for more experienced ones.

I often tell readers not to rely on one metric or ratio. There’s simply no magic formula for stock success. Instead, investors should consult a broad spectrum of numbers to get a clear view of a company’s worth. Having said that, one of the best ratios out there is EV/EBITDA. In fact, some academic research has shown that it’s the single-best valuation measure there is.

So what do all these letters mean? I’ll break it down for you in plain English. EV/EBITDA stands for Enterprise Value divided by Earnings Before Interest, Taxes, Depreciation and Amortization.

Let’s start with the numerator, Enterprise Value (sometimes called total enterprise value), which is basically a fancier version of a company’s market value.

To calculate EV, you start with a company’s market value (the number of shares times the market price). You then add the amount of debt they hold, both short-term and long-term, and at current market value. Then you subtract the amount of cash they have.

This makes sense, because if you’re going to buy out a company, you’re acquiring their debt too, and you can pocket the cash.

Those are the most important differences between EV and market cap, but Enterprise Value also includes things like minority ownership in other companies. There are lots of public companies that own small stakes in other public companies. These may be spin-offs in which they’ve held onto some shares. Perhaps they were considering a merger. The problem is that when an asset you own soars in price, it inflates your equity and therefore tends to lower your ROE, even though you didn’t do anything.

Now let’s turn to the denominator, EBITDA, which stands for Earnings Before Interest, Taxes, Depreciation and Amortization. When we look at a business, we want to know about the dollars coming in compared with the dollars going out. Ideally, we want to isolate the numbers that are closest to showing us the firm’s pure business efficiency. In that regard, EBITDA is beneficial because it tries to be neutral about the company’s capital structure (that’s why we don’t include interest).

Think of it as taking all the revenue and subtracting the costs that solely go into running the business. It’s the business end of the business separated from the financing end of the business. When you look at net income, you’re also factoring in what the CFO has been up to, and of course, Uncle Sam’s cut. While those are important, these variables are a step removed from business operations. The downside of EBITDA is that it can be abused by companies declaring as “one-off” costs things that should really be considered normal costs.

Let me add another important generalization. Strong companies aren’t normally done in by too much debt. It’s certainly possible, and has happened many times. But the more common path is that weak companies acquire too much debt because they’re weak, in an attempt to cure their weakness.

You can find the EV/EBITDA for a stock on Yahoo Finance. Click on the Key Stats page, and it’s the ninth one down. As a rule of thumb, any EV/EBITDA below 10 is the sign of a good value.

Posted by on February 11th, 2014 at 9:50 am

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.