By Puah Soon Lim
Today’s post is a fairly new development. It became popular during the dot-com bubble in the year 2000. I have received a lot of question on this one from newbie investors as well as the more experienced ones.
There are actually some academic researchers that purportedly claim that this is the single most important ratio in the valuation of a business. My view is that it is just one additional tool that investor should have in their arsenal. Both Warren Buffett and Charlie Munger have expressed their dislike for this number during the years leading up to the dot-com bubble.
I will start off by explaining the numerator first.
In the numerator, we have the Enterprise Value (sometimes also referred to as total enterprise value), primarily it is looking at valuing a company from the perspective of both the equity holder and the bondholder. If you are familiar with the concept of market capitalization, you are halfway there to understanding enterprise value(EV). Market capitalization is simply the outstanding shares multiplied by the share price. It gives the market value of the company from the perspective of the shareholder. To get at the perspective of value from all stakeholder, including suppliers, lenders, and banks, you add to market capitalization with the total amount of debt, and then you subtract the cash. The equation looks like this:
Enterprise Value = Market Capitalisation + Total Debt - Cash or Cash Equivalent
The basic idea is that if you want to buy up the entire company, you have to assume all the obligation of the company but you get to keep the cash.
Now let us look at the denominator, EBITDA, which stands for Earnings before interest and taxes, depreciation and amortization. Before we add in depreciation and amortization, we have another familiar term here, EBIT, which is operating income. EBIT, operating income is a number that can be claimed by everyone, lenders, shareholders and the taxman. It is a number that hasn't consider interest payment and tax expense yet. As such, this makes EBIT consistent or congruence with the numerator. EBIT levels out the different capital structure of different firms, and it gives us a number that is as close as possible to a firm’s business efficiency.
The key to understanding EBITDA is then answering the question: why add back depreciation and amortization?
Depreciation and amortization are another one of that jargon that beginner-investors struggle with. Let me try to give you some clarity on that.
Basically, we depreciate trucks and buildings and airplanes. We amortize intangible assets like patents trademarks and software. What we are trying to do in both cases is to spread the cost of a long-term asset over many years - a concept known as capitalization. In using the term depreciation, we are capitalizing a physical asset and when we use the term amortization, we are referring to the nonphysical or intangible asset.
Both depreciation and amortization are subject to a lot of judgment and estimation. That is why you add them back. Another reason that you add them back is also that both these two numbers are a non-cash expense. It is allocated but you don’t have any cash outflow as a result. Most analysts think that when you add depreciation and amortization back to EBIT (Operating Income), you have a number that is perceived as a proxy for future cash flow.
EBITDA makes it a lot easier to compare businesses because a lot of companies have different depreciation and amortization policies. When you use a number such as EBITDA, you level out all these different capitalization policies, and you level out the different capital structure. As a result, you can compare companies across a much broader spectrum. Also, there are more companies with a positive EBITDA than Net Income. So if you are using the PE ratio, you may et some companies with negative earnings which makes the number meaningless. However, the downside of EBITDA is that it can be abused by companies capitalizing “one-off” costs and spreading it over many years.
**The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.
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