What is the EV/EBIT Ratio?
The enterprise value to earnings before interest and taxes (EV/EBIT) ratio is a metric used to determine if a stock is priced too high or too low in relation to similar stocks and the market as a whole. The EV/EBIT ratio is similar to the price to earnings (P/E) ratio; however, it makes up for certain shortcomings of the latter ratio.
The EV/EBIT ratio compares a company’s enterprise value (EV) to its earnings before interest and taxes (EBIT). EV/EBIT is commonly used as a valuation metric to compare the relative value of different businesses. While similar to the EV/EBITDA ratio, EV/EBIT incorporates depreciation and amortization.
Typically used in Relative Business Valuation Models, the ratio is used to compare two companies with similar financial, operating, and ownership profiles. For further information on Comps, please check out our article on Comparable Trading Multiples.
Importance of Enterprise Value
The EV/EBIT ratio makes up for areas of measurement where the P/E ratio can fall short. In order to do so, the enterprise value is used in the metric.
Enterprise value is the total value of a company. It takes into account the entirety of the value assigned to the company by the market, which means that all interests and asset claims – those from both equity AND debt – are included in the calculation.
The enterprise value of a company is specifically valuable when used as a tool to get the clearest idea of its true value, or what it’s actually worth in the market. It is important for companies that might be looking to buy the firm or to those looking to understand what it might cost in the event of a takeover.
The formula for enterprise value is as follows:
Enterprise Value = Market Cap + Market Value of Debt – All Cash and Cash Equivalents
Market Capitalization = Share Price x Number of Shares
Importance of the EV/EBIT Ratio
The EV/EBIT ratio is a very useful metric for market participants. A high ratio indicates that a company’s stock is overvalued. Such a situation, while beneficial for an immediate sale of shares, can spell disaster when the market catches up and attaches the proper value to the company, causing share prices to plummet.
Conversely, a low EV/EBIT ratio indicates that a company’s stock is undervalued. It means that share prices are lower than what is an accurate representation of the company’s actual worth. When the market finally attaches a more appropriate value to the business, share prices and the company’s bottom line should climb.
Ultimately, the lower the EV/EBIT, the more financially stable and secure a company is considered to be. However, the EV/EBIT ratio can’t be used in isolation. Analysts and investors should use the ratio alongside others to get a full picture of a company’s financial state and actual worth, whether the market’s interpretation of value is accurate, and how likely the market is to correct for flawed valuation.
Interpretation of EV/EBIT Ratio and Example
Though less commonly used than EV/EBITDA, EV/EBIT is an important ratio when it comes to valuation. It can be used to determine a target price in an equity research report or value a company compared to its peers. The major difference between the two ratios is EV/EBIT inclusion of depreciation and amortization. It is useful for capital-intensive businesses where depreciation is a true economic cost.
In our example, Company A is going public and analysts need to determine its share price. There are five similar companies to Company A that operate in its industry, Companies B, C, D, E, and F. The EV/EBIT ratios for the companies are 11.3x, 8.3x, 7.1x, 6.8x, and 10.2x, respectively. The average EV/EBIT ratio would be 8.7x. A financial analyst would apply the 8.7x multiple to Company A’s EBIT to find its EV, and consequently its equity value and share price.
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