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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.
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