Thursday, October 19, 2006

EV/EBITDA

As I have mentioned before, on Wall Street, when one no. is divided by the other, cults are formed. This ratio is behind one of the biggest, most controversial cult around. Why is it so? First, because it is very difficult to pronounce. It has 5 syllabus. There are only about 10 words in Singlish with 5 syllabus, so most Singaporeans won't be able to pronounce it, including the blogger who writes this blog.

EV/EBITDA, pronounced as (EE-VEE-EE-BIT-DAH) tries to measure the cheapness of a stock. i.e. similar to other valuation metrics like PER or PBR. Pls do not try to pronounce it as EVITA, I know it is very tempting but pls don't. Regardless of whether you are a fan of Madonna or Britney Spears.

EV stands for Enterprise Value which is the value of the entire firm to both shareholders and debtholders. Its formula is shown below:

EV = Market Cap + Net Debt
Market Cap = Read this post
Net Debt = Total Debt - Cash

And EBITDA stands for Earnings Before Interest, Tax, Depreciation and Amortization. Whatever that means. Well for those really interested, read this post. For those really not interested, well let's just say EBITDA tries really hard to measure some kind of profit (not the kind most good old value investors would like lah).

So, in essence, EV/EBITDA tries to measure the intrinsic value or cheapness of a company, just like PER or PBR. But it looks at it from the perspective of both the shareholder and the debtor. (The other two ratios only look at it from the shareholder's perspective.)

On top (the numerator), it takes into account both market value (or market cap) of the company, and its debt. At the bottom (the denominator), it looks at profits before interest, tax and even depreciation. Well from this ratio's creator's point of view, this is profit attributable to both the shareholder and the debtholder.

So, there you have it, a new ingenious ratio, and a cult is born. EV/EBITDA followers now flood the markets. Rituals are performed now and then when analysts hold hands and chant EV/EBITDA 20 times, and the leader shouts "hip hip", and the rest let out "hurray". Like Singapore secondary schools' sports day.

Ok, just kidding, shit like this don't happen anymore. Singapore secondary schools have moved on to Queen's "We'll Rock You", which used to be a JC thingy. But here's what's really important. EV/EBITDA ranges from 5-25x nowadays with fair value usually at 10-15x.

See also Financial Ratios
and SWOT analysis
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