The flaws, uses and illustrations of EV to EBITDA ratio

Published on:

November 30, 2019

Reading Time: 3 Minutes.

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Enterprise value (ev) is the market value of the debt and equity less cash held by the company. Earnings before interest, taxes, depreciation, and amortization (ebitda) is a proxy for how much cash flow does the business generates. By dividing the enterprise value by ebitda numbers, you discover how long will it take for the company to pay back the initial investment.

The shorter the period the better it is. For example, a business that generates $33,000 a year is more attractive than a business that makes $14,000, assuming both will last and cost the same.

The ev to ebitda ratio represents this idea. "What a ratio of eight times ev to ebitda," writes Michael Shearn in *The Investment Checklist*, "is that the investment will pay itself in eight years."

Read how to calculate ev to ebitda ratio on Investopedia or visit corporatefinanceinstitute.com for ways to compare ev to ebitda ratios among companies.

In this essay, I describe the ratio's main weaknesses and how you can better prepare for them. I end the article with a few examples of companies trading at low ev to ebitda ratios.

There is a reason why Charlie Munger called ebitda earnings "bullshit earnings." In his mind, ebitda misses out on two key points: the amount of leverage and the amount of capital expenditures required to maintain the business.

Another flaw of the ratio is that it looks at a single point in time. But what matters to investors are trends over time. That is, whether earnings will grow in the future is more important than current earnings or last year's earnings.

For example, in June of this year, I bought the stock of Signet Jewelries (SIG on Nyse) One of the reasons I purchased SIG was because for the prior seven years, the average was $800 million. But because the 2018 was loss $579 million, the stock had more than halved. to cannot pick up such a discrepancy.

Like most things in life, the problem does not lie in the ev to ebitda ratio but how the user intends to use it. I typically use ev to ebitda ratio to quickly screen for cheap stocks[1]. Other investors use the inverse logic; they use the ratio to estimate how valuable a company is. They assume that the higher the ratio, the more valuable the company.

Yet, even with the flaws mentioned, ev to ebitda ratio is widely used, and ebitda figures are widely accepted. Read any loan covenants of a publicly-traded firm and you will see that lender covenants that address ebitda figures. That is, if ebitda for a quarter falls below a specific number, a higher interest rate will be charged.

And so, to use Silicon Valley nomenclature, this ratio exhibits a "network effect." One of its strengths is that it is widely used by both companies and by Wall Street analysts.

Take, Luca Franza of Ausonio Fund as example.In the now famed investment thesis for Rain Industries, he writes:

"Rain trades at a P/E of 2.7x and EV/EBITDA multiple of 5.1x. Using cyclically adjusted earnings and EBITDA, which we will assume to be the average over the last five years, Rain trades at a P/E of 1.7x and EV/EBITDA of 4.2x."

Another use of the ev to ebitda ratio is that it allows us to observe a company's valuation over time. Canterbury Consulting shows, in a quarterly asset class report, that for the Russell 2000, a popular index, / was 16 times, while the 10-year average ratio was 14 times, and. For the S&P500, Canterbury researchers show that the current TDA was 1mes, while the 10-year average was ten times. You can download the Canturbury report.

When bored, I enjoy finding out the ev to ebitda ratio of portfolio companies owned by asset managers I admire. For example, a few weeks ago, I reviewed Third Street Avenue Capital Management. I saw that for the 31 companies Third Street owned as of the second quarter of this year, most portfolio companies ev to ebitda was in the double digits. Only Carter Bank Trust Advansix Inc. traded at a ratio of six times; MYR Group at a ratio of seven times. The other single-digit companies, at nine times the ev to ebitda, were Seaboard Corporation, Comfort Systems and TRI Pointe Group and Kaiser Aluminum Corporation.

In Pen&Paper, I only write about companies I am personally invested in, and on finance topics, I find it important to share.

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I often screen for stocks trading at low ev/ebitda. While it is insufficient to make an investment decision based on the ratio, it does serve as a starting point or as a filter mechanism. I conclude this essay with three companies in my portfolio that are trading below three times the ev to ebitda ratio.

First, the sport-equipment manufacturer Nautilus' enterprise value is $54 million, and ebitda is $31 million. Second, Flexsteel Industries, the sofa manufacture, enterprise value is $102 million, and 2018 ebitda is $33 million. Third, Gulfport Energy, a producer of natural gas, enterprise value is $2,670 million, and 2018 ebitda is $1,046 million.

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