What is EV to EBIT Ratio?

Let us look at Facebook vs. General Motors Valuations from the above graph. Facebook is trading at EV to EBIT of 24.21x; however, General Motors’ multiple is around 9.16x. Does this mean that General Motors is trading cheap, and we should buy General Motors compared to Facebook?

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The answer lies in understanding what EV to EBIT is all about. In this article, we look at EV to EBIT in detail –

What is Enterprise Value?

Enterprise Value is the total value of the firm. Enterprise value depicts the value to the overall stakeholders, including the debt holders, shareholders, minority shareholders, and preference shareholders.

The formula for Enterprise value is as follows.

EV = Market Cap + Debt + Minority Interest + Preference Shares – Cash & Cash Equivalents.

Enterprise value can be considered the total consideration at which the investor can buy the company. It implies that the buyer will also assume the company’s debt, which he will have to pay off.

For a detailed note on Enterprise Value, please refer to Enterprise ValueEnterprise ValueEnterprise value (EV) is the corporate valuation of a company, determined by using market capitalization and total debt.read more Guide.

What is EBIT?

Let us have a look at the Income Statement of Colgate above. Is the Operating profit in Colgate EBIT (Earnings Before Interest and TaxesEarnings Before Interest And TaxesEarnings before interest and tax (EBIT) refers to the company’s operating profit that is acquired after deducting all the expenses except the interest and tax expenses from the revenue. It denotes the organization’s profit from business operations while excluding all taxes and costs of capital.read more), or EBITDA (Earnings Before Interest Taxes Depreciation & Amortization)?

source: Colgate SEC Filings

The above Operating Profit of Colgate is EBIT. EBIT is defined as any company’s profit, including all expenditures just leaving income tax and interest expenditures. However, the EBITDA measure is good for analyzing and comparing profitability between firms and businesses as it removes the impacts of accounting and financing decisions.

Please look at this guide for detailed differences between EBIT vs. EBITDA GuideEBIT Vs. EBITDA GuideEBIT signifies the operating profit the company makes before the inclusion of interest and tax expenses. In comparison, EBITDA determines the company’s overall operational profitability by summing the depreciation and amortization expenses to the operating profit.read more.

EV to EBIT Formula and Interpretation

EV/EBIT multiple answers the query “What is the company’s valuation worth per Operating Profit dollar.”

EV to EBIT formula = Enterprise Value / EBIT =

EV / EBIT = (Market CapitalizationMarket CapitalizationMarket capitalization is the market value of a company’s outstanding shares. It is computed as the product of the total number of outstanding shares and the price of each share.read more + Debt + Minority InterestMinority InterestMinority interest is the investors’ stakeholding that is less than 50% of the existing shares or the voting rights in the company. The minority shareholders do not have control over the company through their voting rights, thereby having a meagre role in the corporate decision-making.read more + Preference SharesPreference SharesA preferred share is a share that enjoys priority in receiving dividends compared to common stock. The dividend rate can be fixed or floating depending upon the terms of the issue. Also, preferred stockholders generally do not enjoy voting rights. However, their claims are discharged before the shares of common stockholders at the time of liquidation.read more – Cash & Cash Equivalents)/EBIT

  • The above formula in detail measures if a company’s share is expensive or cheap compared to the broader market or competing firm.This ratio is an improved version of the traditional P/E multiple that overcomes the limitations of PE ratioPE RatioThe price to earnings (PE) ratio measures the relative value of the corporate stocks, i.e., whether it is undervalued or overvalued. It is calculated as the proportion of the current price per share to the earnings per share. read more as it also has a balance sheet. Therefore, rather than just using the company’s share price, the company employs enterprise value that includes debt.PE ratio is the most commonly used and easiest valuation technique to measure any company’s capability to deliver profits compared to the market. This multiple is occasionally used against the P/E multiple to relate profit expansion among companies in industries having huge quantities of debt like high capital intensiveCapital IntensiveCapital intensive refers to those industries or companies that require significant upfront capital investments in machinery, plant & equipment to produce goods or services in high volumes and maintain higher levels of profit margins and return on investments. Examples include oil & gas, automobiles, real estate, metals & mining.read more businesses.Key analysts most often study EV/EBIT to promptly identify the firm’s trading valuation multiples. A large or small multiple signifies that the firm is expected to be either overvalued or undervalued. Keeping all other things unchanged, the smaller this ratio comes out to be, the healthier.Investors are advised to go through any company’s EV to EBIT ratio and make it a core tool to identify the company’s earnings capabilities while also comparing it with other companies to get a clearer insight into which stock is best for investments at that point of time, in the short-term or over the longer term. Further, this ratio is generally believed to be used by Buffet and Greenblatt for determining any business’s health.

Calculation of Enterprise Value = (Market Cap + Debt + Minority Interest + Preference Shares – Cash & Cash Equivalents)/EBIT

Market Capitalization = Number of Shares Outstanding x Current Price.

Number of outstanding sharesNumber Of Outstanding SharesOutstanding shares are the stocks available with the company’s shareholders at a given point of time after excluding the shares that the entity had repurchased. It is shown as a part of the owner’s equity in the liability side of the company’s balance sheet.read more (as of last reported 10K) = 477 million

EV to EBIT – Forward vs Trailing

This multiple can be further subdivided into Investment BankingInvestment BankingInvestment banking is a specialized banking stream that facilitates the business entities, government and other organizations in generating capital through debts and equity, reorganization, mergers and acquisition, etc.read more Analysis.

  • Trailing MultipleForward Multiple

They were trailing Multiple (TTM or Trailing Twelve Months)  = Enterprise Value / EBIT over the previous 12 months.

Likewise, the Forward Multiple = Enterprise Value / EBIT over the next 12 months.

The key difference here is the EBIT (denominator). We use the historical EBIT in the trailing multiple and the forward or EBIT forecast in the forward multiple.

Let us look at the example below to understand how they are used.

There are six companies A, B, C, D, E, and F.

You are provided with the Current Price, Enterprise value, EBIT, and EV to EBIT forecasts of all six companies. You need to find the following –

  • Which company will you invest in?Which company is the worst from the valuation point of view?

Which company should you invest in?

The answer to this question lies in the knowledge of trailing and forward multiple.

Please take a look at the table above. You will note that EV to EBIT is lowest for company B in 2016A at 26.7x, while it is highest for Company D at 80.0x. It makes us believe that Company B is the cheapest. However, this is an incorrect conclusion! You should never value a firm based on what has already happened in the past. Instead, you should give more weight to the company’s future, and therefore forward EV/EBIT becomes critical. If you take forward EV to EBIT of Company B, you will note that it increased dramatically to 40.0x in 2018. On the other hand, the lowest forward multiple is that of Company D. This is what you should look at from the investment point of view.

Which company is the worst from the valuation point of view?

Again, the answer lies in analyzing the estimated EV to EBIT. We note that even though Company B had the cheapest multiple in 2016 (at 26.7x), its EV to EBIT continuously increased to 33.3x and 40.0x in 2017 and 2018, respectively. It happened due to a decrease in EBIT in 2017 and 2018.

Also, note that even though Company C has a higher multiple (48.6x) than that of Company B (40.0x), going by the trend, it seems like Company B will be worse off in 2019E.

Can I use EV to EBIT in the Services Sector?

Services companies do not have a large asset base; their business model is dependent on Human Capital (employees). Due to this, depreciation and amortization in Services Companies are generally non-meaningful.

The difference between EBIT margin and EBITDA marginEBITDA MarginEBITDA Margin is an operating profitability ratio that helps all stakeholders of the company get a clear picture of the company’s operating profitability and cash flow position. It is calculated by dividing the company’s earnings before interest, taxes, depreciation, and amortization (EBITDA) by its net revenue. EBITDA Margin = EBITDA / Net Salesread more can tell us the relative amount of depreciation and amortization in the Income Statement. It is expected from a services firm as they operate as an Asset Light model. The graph below notes that the difference between EBIT Margin and EBITDA Margin for Infosys is approximately 1.24% (27.34% – 26.10%).

source: ycharts

Since the difference between EBIT and EBITDA is not much, you can easily use EV/EBIT or EV/EBITDA for a Software company’s valuations.

Other services sectors where you can apply EV to EBIT are –

  • Internet Tech & ContentSoftware ApplicationsAdvertising AgenciesMarketing Services

Can I use EV to EBIT in the Oil & Gas Sector?

Oil & Gas companies are Capital Intensive companies that invest heavily in plants and manufacturing setup and are dependent on continuous investments in assets to manufacture finished products. Therefore, its depreciation and amortization are relatively higher with a higher asset base.

Now let us compare the above graph with that of Exxon. Exxon is an Oil & Gas company (highly capital intensive firm). We note that the difference between EBIT Margin and EBITDA margin is very high – approximately 8.42% (13.00% – 4.58%). Heavy investments in Plant Property and EquipmentPlant Property And EquipmentProperty plant and equipment (PP&E) refers to the fixed tangible assets used in business operations by the company for an extended period or many years. Such non-current assets are not purchased frequently, neither these are readily convertible into cash. read more lead to high depreciation and amortization figures.

Using this multiple in the Oil & Gas sectors will be incorrect due to the presence of higher depreciation and amortization. Higher depreciation and amortization can lead to very low EBIT values. Additionally, depreciation policies may differ between companies, with one following theStraight Line Depreciation Method is one of the most popular methods of depreciation where the asset uniformly depreciates over its useful life and the cost of the asset is evenly spread over its useful and functional life. read more straight-line methodStraight-line MethodStraight Line Depreciation Method is one of the most popular methods of depreciation where the asset uniformly depreciates over its useful life and the cost of the asset is evenly spread over its useful and functional life. read more and the other with theAccelerated depreciation is a way of depreciating assets at a faster rate than the straight-line method, resulting in higher depreciation expenses in the early years of the asset’s useful life than in the later years. The assumption that assets are more productive in the early years than in later years is the main motivation for using this method. read more accelerated depreciationAccelerated DepreciationAccelerated depreciation is a way of depreciating assets at a faster rate than the straight-line method, resulting in higher depreciation expenses in the early years of the asset’s useful life than in the later years. The assumption that assets are more productive in the early years than in later years is the main motivation for using this method. read more method. Therefore to make the right comparison, EV to EBITDA is the correct valuation multiple in this case.

Other sectors where we should avoid using EV to EBIT (preferable use EV to EBITDAEV To EBITDAEV to EBITDA is the ratio between enterprise value and earnings before interest, taxes, depreciation, and amortization that helps the investor in the valuation of the company at a very subtle level by allowing the investor to compare a specific company to the peer company in the industry as a whole, or other comparative industries.read more) are the high capital intensive sectors like –

  • ManufacturingUtilitiesAutomobile SectorMiningEnergyTelecom

Conclusion

The EV-to-EBIT multiple has a unique benefit of valuing a firm despite its capital arrangement, making the ratio attractive among analysts.

  • Enterprise Value to SalesEnterprise Value to EBITDAEnterprise Value vs. Equity Value