What it means
The top of the ratio is enterprise value, which captures what it would cost to buy the entire business, including its debt and net of its cash. The bottom is EBITDA, which measures operating earnings before financing, tax and the accounting write-down of assets.
Both sides therefore ignore the way the business is financed, so the ratio compares like with like. A result of 8 means the market values the business at eight times its annual EBITDA.
A lower multiple suggests a cheaper business relative to its earnings, while a higher multiple suggests investors expect strong growth or low risk. Neither is good or bad on its own, because the right level depends on the sector.
The ratio is popular in takeovers and private equity because it is not distorted by different debt levels or tax rates. A buyer can quote a price as a multiple of EBITDA and compare it with the multiples paid in similar deals.
Advisers often talk about a business being worth a certain number of times EBITDA. There are limits.
EBITDA ignores capital spending, so a business that needs heavy investment in equipment can look cheap on this ratio but cost a great deal to maintain. Comparing against a ratio based on free cash flow, or against EBIT, offers a useful cross-check.
Using the ratio correctly means matching the numbers in time and definition. If enterprise value uses today's price, the EBITDA can be the last reported year, which gives a trailing multiple, or the expected year ahead, which gives a forward multiple.
Mixing the two leads to errors, so the basis should always be stated. It is also wise to adjust EBITDA for one-off items, so the figure reflects normal trading.
Analysts remove unusual costs or gains, such as restructuring charges or the profit on selling a building, but should explain every adjustment.
In practice
Real-world examples
Example 1
A private equity buyer is offered a manufacturing business with EBITDA of $15,000,000. Similar companies have recently sold for about 7 times EBITDA, so the buyer values the target at around $105,000,000. The seller's request of $150,000,000 is challenged using this benchmark.
Example 2
An investor screens listed supermarkets for value. One trades at 6 times EBITDA and another at 9 times. She investigates why the second is more expensive and finds that it is growing faster and has less debt.
Example 3
A founder selling a software business is told that comparable firms are valued at 12 times EBITDA. His adviser points out that his business is smaller and more reliant on a few customers, which may justify a lower multiple. The founder prepares evidence of recurring revenue to support a higher valuation.
Think of it
EV/EBITDA shows the total cost to buy the company relative to its cash operating profits.
Formula
Calculation
Enterprise value to EBITDA = Enterprise value / EBITDA
Suppose a company has a market capitalisation of $320,000,000, debt of $100,000,000 and cash of $20,000,000, and its EBITDA for the last year was $50,000,000.
Enterprise value = 320,000,000 + 100,000,000 - 20,000,000 = $400,000,000.
Enterprise value to EBITDA = 400,000,000 / 50,000,000 = 8.0 times.
If a rival with the same size of earnings trades at 10 times EBITDA, the first company looks cheaper, although its growth and risk should be compared before drawing a conclusion.Case study
Seen in the real world
Alpine Coatings is an illustrative, fictional chemicals company whose owners hoped to sell for 10 times EBITDA, as recent headlines suggested. The company's EBITDA was $8,000,000.
Potential buyers pointed out that the company's capital spending was nearly equal to its EBITDA, which left little free cash. After adjusting for these needs, buyers offered 6.5 times EBITDA, or $52,000,000, rather than the $80,000,000 the owners expected.
The owners' adviser also showed that two deals quoted in the press involved businesses with far lower capital needs. The illustrative lesson is that a multiple only makes sense when the business being compared has a similar capital intensity, growth and risk.
Watch out
Common mistakes
- Using market capitalisation instead of enterprise value as the numerator, which mismatches the two sides of the ratio.
- Comparing multiples across industries with very different growth and capital needs.
- Using EBITDA from a different period or basis than the enterprise value without saying so.
Questions
People also ask
What is a good enterprise value to EBITDA multiple?
There is no universal figure, as it varies by sector, growth and risk, so compare with close peers and recent comparable deals.
Why use enterprise value instead of share price?
Enterprise value includes debt and cash, so it allows companies with different financing to be compared fairly against operating earnings.
What is the difference between a trailing and a forward multiple?
A trailing multiple uses the last reported twelve months of EBITDA, while a forward multiple uses a forecast of the coming period.
Watch