EV/EBITDA: comparing companies fairly
Market value shows only part of what a company costs. Anyone who wanted to buy it outright would also have to take on its debt. EV/EBITDA compares this whole price with the result from the business – and so makes companies with and without debt comparable.
The idea
Imagine you buy a house for €300,000. But there is still a €200,000 loan on the house, which you take over. Then the house really costs you €500,000 – not €300,000.
Stocks work the same way. Market value, share price times number of shares, is only the price for the owners. Debt comes on top. Only both together are the price for the whole company: the enterprise value, EV for short.
The formula
- Market value
- share price times number of shares
- Debt
- loans and bonds the company has taken on
- Cash
- cash and quickly available investments
Cash is subtracted because a buyer could use it right away to pay off part of the debt. Enterprise value is then divided by EBITDA:
- EBITDA
- earnings before interest, taxes, depreciation and amortization
Why EBITDA?
EBITDA is the result before interest, taxes and depreciation are subtracted. That sounds technical, but the reason is simple: interest depends on how much debt a company has. If you look at the whole price including debt, you also need a result that comes before interest – otherwise the debt would count twice. That way companies with a lot and with little debt are compared on the same basis.
The worked example
Two made-up companies both generate EBITDA of €100 million. By market value, Company B looks much cheaper:
| Item | Company A | Company B |
|---|---|---|
| Market value | 1,000 | 600 |
| + Debt | 0 | 900 |
| − Cash | 100 | 100 |
| = Enterprise value | 900 | 1,400 |
| EBITDA | 100 | 100 |
| EV/EBITDA | 9 | 14 |
Company B costs only €600 million on the stock market. But anyone taking it over completely pays €1,400 million, because €900 million of debt comes on top. For the same result from the business, B is therefore clearly more expensive than A. Market value alone would have shown exactly the opposite.
Comparing correctly
As with the P/E ratio, there is no fixed good value. A software company with high margins and strong growth almost always carries a higher EV/EBITDA than a steelmaker. The useful comparison is with similar companies in the same industry and with the company's own history over many years.
The measure does not fit banks and insurers. For them, debt is not an add-on to the business but the business itself: they borrow money to lend it on. There are dedicated valuation models for them.
Three common mistakes
See the whole price, not just the share price.
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Frequently asked questions
What is a good EV/EBITDA?
There is no fixed value. It depends on industry, growth and margins. The meaningful comparison is with similar companies and with the company's own earlier years.
How is it different from the P/E ratio?
The P/E ratio compares market value with profit after interest and taxes. EV/EBITDA compares the whole price including debt with the result before them. That way it does not matter how a company is financed.
Why is cash subtracted?
Because a buyer could use the cash in the company right away to pay off debt. It therefore lowers the price they really pay.
Can I use EV/EBITDA for banks?
No. For banks, debt is the raw material of their business. Models based on book value and return on equity suit them better.
Not investment advice. All content is for informational and educational purposes only. Companies A and B are made up.