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EV/EBITDA Is Not the Magic Pill for Valuation

November 07, 2012 | About:

EV/EBITDA = (Market Value of Equity + Market Value of Debt - Cash) / Earnings before Interest, Depreciation & Amortization (EBITDA)

Benefits of Using EV/EBITDA instead of P/E as a Valuation Tool

EV/EBITDA allows investors to compare the valuation of loss-making companies (but with positive EBITDA), stocks with different capital structure, and capital-intensive firms with varying depreciation accounting policies.

Caveats to Buying Low EV/EBITDA Stocks

High capital expenditure firms are not penalized with the add back of depreciation for EV/EBITDA, unlike P/E.

- Firms with high maintenance capital expenditure needs will have a high asset turnover ratio or a high PPE-to-sales ratio and this will be reflected in a lower return on invested capital (ROIC) or lower ROE.

EV/EBITDA Independent of Financing Decisions Unlike P/E

- Stocks with high debt-to-equity ratios may look cheaper on EV/EBITDA versus P/E.

Future EBITDA Matters, Not Current EBITDA

- For stocks with analyst coverage by brokerages or banks, consensus analysts’ estimates of future earnings will be useful in arriving at the projected EBITDA. Prudent investors will take the lower end of consensus analysts’ estimates.

- EBITDA Is Still Not Cash Flow

EBITDA may be used as a proxy for cash flow, but it is still not cash flow in reality. Like P/E, EV/EBITDA does not incorporate high working capital and capex into the valuation.

In Closing

Similar to P/E and P/B ratios, price ratios should not be used independently but compared with other relevant metrics to determine true valuation mismatches.

About the author:

Mark Lin
Mark is a private value investor and runs the Cheapskate Investing website which borrows from the wisdom of value investing giants, using a systematic quantitative screening approach to filter the global stock markets for cheap deep-value cigar-butts and wide-moat compounders. He publishes value investing case studies, investment checklists, and potential stock ideas on the Cheapskate Investing blog. He is also a regular contributor to various value investing communities.

Visit Mark Lin's Website

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