COMMENT
How To Use EBITDA

By Ed Bowsher (TMFArkle)
January 4, 2006

The price/earnings (p/e) ratio is probably the most widely used investment tool certainly by private investors. But it's not perfect. Other ratios have their uses. In particular, one called EV/EBITDA.

Let me explain the jargon. EV stands for enterprise value, which is market cap plus net debt. By including net debt, EV tells you the true cost of buying a particular business.

EBITDA is one of many possible measures of profit, and stands for earnings before interest, tax, depreciation and amortisation. In other words, it's operating profit plus depreciation and goodwill amortisation.

Critics of EBITDA often point to the late-90s stock market boom. Back then, over-valued technology companies would boast about their EBITDA profits while they made large pre-tax losses.

It's a fair criticism. Young technology companies often have expensive capital assets where the value is falling fast. So ignoring depreciation can be misleading.

Indeed, some wags in 2000 suggested that a better name for EBITDA would be EBBS (earnings before bad stuff.)

However, the p/e ratio isn't perfect either. Different companies may have different policies on depreciation and other accounting conundrums. So a quick glance at two p/e ratios may not tell you the whole story.

The other problem is that the p/e ratio doesn't take debt into account.

Imagine you're comparing Company A and Company B. Both companies have market caps of £100m and are trading on a p/e ratio of 15. Their growth prospects are similar.

At first glance, they appear to be equally attractive investments. Company A, however, has net debt of £30m whereas Company B has none.

So if I was chief executive of Company C and I could take over A or B for £100m, I'd go for Company B with no debt.

In other words, Company B is the more attractive than Company A because B has a lower enterprise value.

So when it comes to ratios, why not use EV/earnings instead of a p/e ratio?

It's tempting, but wrong.

When valuing an enterprise, we want to know what the company is worth before any class of capital (debt or shares) has taken its slice. So we should use a profit figure where interest hasn't yet been paid. Once you deduct interest, the debtholders (lenders) have had their cut for the year.

One option is EV/operating profit. There's a lot to be said for this ratio, but it doesn't get round the problem of accounting conundrums outlined above.

EV/EBITDA does get round the issue of accounting conundrums, but it ignores the fact that capex may be required to replace assets when they're worn out. That's why capital-intensive businesses tend to trade on lower EV/EBITDA ratios than capital-light companies.

In summary, no ratio is perfect. If you have the time, it's worth looking at as many ratios as possible. That should give you a fuller picture of any company.

More: What is EBITDA? | Useless Financial Ratios