Business, Legal & Accounting Glossary
EV/EBITDA Ratio is a very commonly used metric for estimating business valuation of companies. This valuation metric compares the value of a company, inclusive of debt and other liabilities, to the actual cash earnings exclusive of the non-cash expenses. It measures the price (in the form of enterprise value) an investor pays for the benefit of the company’s cash flow (in the form of EBITDA). This metric is also known as Enterprise Multiple and EBITDA Multiple.
The main advantage of EV/EBITDA over the PE ratio is that it is unaffected by a company’s capital structure, in accordance with capital structure irrelevance. It compares the value of a business, free of debt, to earnings before interest. The enterprise multiple can be used to compare the value of one company to the value of another company within the same industry. A lower enterprise multiple can be indicative of an undervalued company.
The EV/EBITDA Ratio is not usually appropriate for the comparison of companies in different industries. Capital requirements of industries vary from one another. Therefore, this factor may not give reliable conclusions when compared to a universe of stocks.
Ideally, the performance spread should be “monotonic”, meaning that Quintile 1 outperforms Quintile 2, Quintile 2 outperforms Quintile 3, and so forth.
Using the above process, the stocks from the S&P 500 were sorted into quintiles based on the quarterly EV/EBITDA Ratio versus stocks in the same industry, then evaluated over the 10 year back-test period 2005-2014 with a 3 month rebalance period.
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This glossary post was last updated: 22nd March, 2020