EV/EBIT Ratio

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) ratioPrice Earnings RatioThe Price Earnings Ratio (P/E Ratio) is the relationship between a company’s stock price and earnings per share. It gives investors a better sense of the value of a company. The P/E shows the expectations of the market and is the price you must pay per unit of current (or future) earnings; however, it makes up for certain shortcomings of the latter ratio.

The EV/EBIT ratio compares a company’s enterprise value (EV)Enterprise Value (EV)Enterprise Value, or Firm Value, is the entire value of a firm equal to its equity value, plus net debt, plus any minority interest, used in to its earnings before interest and taxes (EBIT)EBIT GuideEBIT stands for Earnings Before Interest and Taxes and is one of the last subtotals in the income statement before net income. EBIT is also sometimes referred to as operating income and is called this because it's found by deducting all operating expenses (production and non-production costs) from sales revenue..  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 depreciationDepreciation MethodsThe most common types of depreciation methods include straight-line, double declining balance, units of production, and sum of years digits. There are various formulas for calculating depreciation of an asset. Depreciation expense is used in accounting to allocate the cost of a tangible asset over its useful life. and amortizationAmortizationAmortization refers to the act of paying off a debt through scheduled, pre-determined smaller payments. In almost every area where the term amortization is applicable, these payments are made in the form of principal and interest. The term is also closely related to the concept of depreciation..

Typically used in Relative Business Valuation ModelsRelative Valuation ModelsRelative valuation models are used to value companies by comparing them to other businesses based on certain metrics such as EV/Revenue, EV/EBITDA, and P/E, 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.Comps - Comparable Trading MultiplesAnalyzing comparable trading multiples (Comps) involves analyzing companies with similar operating, financial and ownership profiles to provide a useful understanding of: operations, financials, growth rates, margin trends, capital spending, valuation multiples, DCF assumptions, and benchmarks for an IPO

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 valueEnterprise Value (EV)Enterprise Value, or Firm Value, is the entire value of a firm equal to its equity value, plus net debt, plus any minority interest, used in 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 equityEquityIn finance, equity is the market value of the assets owned by shareholders after all debts have been paid off. In accounting, equity refers to the book value of stockholders’ equity on the balance sheet, which is equal to assets minus liabilities. The term, "equity", in finance and accounting comes with the concept of fair and equal treatment AND debtDebtDebt is the money borrowed by one party from another to serve a financial need that otherwise cannot be met outright. Many organizations use debt to procure goods and services that they can’t manage to pay for with cash. – 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 takeoverHostile TakeoverA hostile takeover, in mergers and acquisitions (M&A), is the acquisition of a target company by another company (referred to as the acquirer) by going directly to the target company’s shareholders, either by making a tender offer or through a proxy vote. The difference between a hostile and a friendly.

The formula for enterprise value is as follows:

Enterprise Value = Market Cap + Market Value of Debt – All Cash and Cash Equivalents

Where:

Market CapitalizationMarket CapitalizationMarket Capitalization (Market Cap) is the most recent market value of a company’s outstanding shares. Market Cap is equal to the current share price multiplied by the number of shares outstanding. The investing community often uses the market capitalization value to rank companies = 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 reportEquity Research ReportAn equity research report is a document prepared by an analyst that provides a recommendation for investors to buy, hold, or sell shares of a company. 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 analystFinancial Analyst Role would apply the 8.7x multiple to Company A’s EBIT to find its EV, and consequently its equity value and share price.

Additional Resources

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To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below:

• EBIT vs EBITDAEBIT vs EBITDAEBIT vs EBITDA - two very common metrics used in finance and company valuation. There are important differences, pros/cons to understand. EBIT stands for: Earnings Before Interest and Taxes. EBITDA stands for: Earnings Before Interest, Taxes, Depreciation, and Amortization. Examples, and
• Financial RatiosFinancial RatiosFinancial ratios are created with the use of numerical values taken from financial statements to gain meaningful information about a company
• How to Calculate FCFE from EBIT?How to Calculate FCFE from EBIT?Calculate FCFE from EBIT : Free Cash Flow to Equity (FCFE) is the amount of cash generated by a company that can be potentially distributed to its shareholders. Using the FCFE, an analyst can determine the Net Present Value (NPV) of a company’s equity, which can be subsequently used to calculate the theoretical share price of the company.
• Leverage RatiosLeverage RatiosA leverage ratio indicates the level of debt incurred by a business entity against several other accounts in its balance sheet, income statement, or cash flow statement. Excel template