What it means
Valuation multiples usually put value on top, as in EV/EBITDA, which tells you how many years of EBITDA you are paying for. The EBITDA/EV multiple flips the fraction, so it tells you how much EBITDA each dollar of enterprise value buys.
Because the result is a percentage, it can be compared directly with other yields, such as the return on a bond or on property. Enterprise value is the price of the whole business to all of its funders.
It is calculated as the market value of equity plus debt, minus cash, and it shows what a buyer would effectively pay to take over the operations. EBITDA is used on the top because it measures operating profit before financing, tax and accounting write-downs, which makes it consistent with a value that includes debt.
A higher EBITDA/EV percentage means the business looks cheaper relative to its earnings, while a lower percentage means investors are paying a premium. Some investors rank whole stock markets or sectors by this yield to find bargains.
It can be handy when comparing businesses that are financed in very different ways, because both sides of the fraction are measured before the effect of the financing mix. There are caveats.
EBITDA ignores the cost of replacing equipment, so capital-hungry businesses can look cheaper than they truly are. Enterprise value also moves with market prices every day, and a one-off event such as a large cash balance or a pending lawsuit can distort the figure.
The inverse relationship is simple to remember. If EV/EBITDA is 8 times, then EBITDA/EV is one divided by eight, or 12.5%.
Another way to think about it is as a rough operating return on the price of the business. If you paid the full enterprise value of $12,000,000 for a company earning $1,500,000 of EBITDA, you would receive about 12.5 cents of operating profit for every dollar of price, before tax, upkeep and reinvestment.
That is not the same as a cash return, but it gives a quick starting point for comparison.
In practice
Real-world examples.
Example
An investment analyst screens a list of listed retailers and ranks them from the highest to the lowest EBITDA/EV yield. The top names are then examined more closely for signs that the earnings are about to fall.
Example
A private equity firm evaluating a takeover target compares its 12.5% yield with the 9% yield of a similar company that recently sold. The gap suggests the target may be undervalued, or may carry hidden risks.
Example
A family office compares an investment in a commercial car park business with a corporate bond. Converting the valuation into a percentage yield lets the family office weigh the two options on the same scale.
Formula
Calculation
EBITDA/EV multiple = EBITDA / Enterprise value
Enterprise value = Market value of equity + Debt - Cash
Worked example for a packaging company:
Market value of equity: $10,000,000
Debt: $3,000,000
Cash: $1,000,000
EBITDA: $1,500,000
Enterprise value = $10,000,000 + $3,000,000 - $1,000,000 = $12,000,000
EBITDA/EV = $1,500,000 / $12,000,000 = 0.125, or 12.5%
The equivalent EV/EBITDA multiple is $12,000,000 / $1,500,000 = 8.0 times.
To compare with a rival, suppose another packaging company has an enterprise value of $20,000,000 and EBITDA of $1,800,000. Its EBITDA/EV is $1,800,000 / $20,000,000 = 0.09, or 9.0%, and its EV/EBITDA is about 11.1 times. The first company therefore looks cheaper, though the reasons for the gap should always be investigated.Case study
Seen in the real world.
This case is fictional. Northgate Packaging, an invented manufacturer, had an enterprise value of $12,000,000 and EBITDA of $1,500,000, giving an EBITDA/EV multiple of 12.5%. An investor noticed that competitors traded at yields of around 9%.
Rather than rushing to buy, the investor asked why the gap existed. The answer was that Northgate spent most of its EBITDA on replacing worn machinery, so its true cash earnings were much lower than the headline suggested, and the investor adjusted the offer price accordingly.
The final price was set about 10% lower than the seller first asked, and the investor included a clause linking part of the payment to future capital spending. The deal showed that the multiple is a starting point for questions, not a verdict.
Watch out
Common mistakes.
- Using equity value instead of enterprise value in the denominator. That ignores debt and cash, and makes the result inconsistent with EBITDA.
- Forgetting to subtract cash when calculating enterprise value. Surplus cash reduces the net price a buyer effectively pays.
- Assuming a higher yield always means a bargain. A high yield can signal that the market expects earnings to fall.
Questions
People also ask.
How is it related to EV/EBITDA?
It is the reciprocal, so you can convert either one to the other by dividing one by the figure.
Can the multiple be negative?
Yes, if EBITDA is negative, and then the ratio is not very meaningful for valuation.
Which EBITDA should I use?
Use the same period that the market is pricing, usually the last twelve months or next year's forecast, and apply the same choice to every company you compare.
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