101 Concepts for the Level I Exam
Essential Concept 55: EV Multiples
Enterprise value is measured as:
Enterprise value = Market value of common equity + Market value of preferred stock + Market value of debt – Cash and investments
EV/EBITDA is one of the most widely used enterprise value multiples. It is the ratio of the total company value to EBITDA. The rationales for using EV/EBITDA are as follows:
- For companies with different financial leverage, EV/EBITDA is a better choice than P/E as it is a pre-interest figure.
- It increases the comparability across businesses as the age of the assets (and hence, depreciation and amortization) may vary.
- EBITDA is often positive, whereas EPS can be negative.
The drawbacks for using EV/EBITDA are as follows:
- EBITDA overestimates cash flow from operations if working capital is growing.
- FCFF is more appropriate in valuation than EBITDA because it takes into account capital expenditures. EBITDA will reflect capital expenditures only if depreciation expenses match capital expenditures.
Other income measures used instead of EBITDA includes EBIT, EBITA, and FCFF.
EV/EBITDA is positively related to the expected growth rate in FCFF, profitability and negatively related to the firm’s weighted average cost of capital.