EBIT/EV Multiple
A financial ratio that is used for measuring the earnings yield of a company
What is EBIT/EV Multiple?
EBIT/EV Multiple is a financial ratio that is used for measuring the earnings yield of a firm. Investors and market analysts can use the EBIT/EV multiple to compare the earnings yield of companies having different tax rates and debt levels.
Investors look for higher values of EBIT/EV multiple, as high value implies a low level of debt and a high cash amount. Joel Greenblatt, a Columbia Business School professor and investor, introduced EBIT/EV multiple as an alternate to earnings yield.
Summary
- EBIT/EV multiple is used by investors and analysts to determine the earnings yield and value of a company.
- Joel Greenblatt introduced the EBIT/EV multiple as a substitute for earnings yield to compare companies with different capital structures.
- Higher EBIT/EV multiple values are better for investors, as higher values imply that the company holds a low level of debt and a high amount of cash.
Explanation of EBIT/EV Multiple
EBIT is defined as earnings before interest and taxes, while EV is the enterprise value. Using EV provides a clearer idea of the value of a company than considering the market capitalization alone; hence EV is often used by investors to compare companies while making investment decisions.
EV is also an important part of various ratios used by investors, such as EV/Sales and EV/EBITDA (where EBITDA is Earnings Before Interest, Taxes, Depreciation, and Amortization).
A company’s enterprise value can be calculated as follows:
Enterprise Value = Market Capitalization + Total Debt – Cash and Cash Equivalents
Where:
- Market Capitalization = Current Share Price * Number of Shares Outstanding
- Total Debt = Short-term Debt + Long-term Debt
Some calculations of enterprise value may also include preferred stock and minority interest. However, these are not common in the capital structure of the majority of firms. Hence, preferred stock and minority stock are often not considered in enterprise value calculation.
The enterprise value signifies the amount of money needed to buy the company. Hence, investors prefer firms with a low level of debt and a larger cash amount.
Also, with everything else being equal, a company with more leverage will be riskier. The companies with low debt levels and large cash will show smaller enterprise values, resulting in a higher value of EBIT/EV multiple, implying high earnings yield.
EBIT/EV Multiple Example
Suppose Company XYZ reports $5 billion of EBIT, a debt of $3.5 billion, a market capitalization of $50 billion, and $2.5 billion in cash. On the other hand, Company ABC reports $2.5 billion of EBIT, a debt of $7.5 billion, a market capitalization of $50 billion, and $2.5 billion in cash.
- For Company XYZ, EV = (50 + 3.5 – 2.5) billion = $51 billion
- For Company ABC, EV = (50 + 7.5 – 2.5) billion = $55 billion
EBIT/EV Multiple Calculations
- For Company XYZ, EBIT/EV multiple = $5 billion / $51 billion = 0.098x
- For Company ABC, EBIT/EV multiple = $2.5 billion / $55 billion = 0.045x
The EBIT/EV multiple value for Company XYZ is higher, and it is because Company XYZ reports a higher EBIT, as well as lower debt.
Importance of EBIT/EV Multiple
The EBIT/EV multiple is used by market analysts and investors to determine the value of a company. It compares the company’s profit with its market valuation. Comparison among companies using the EBIT/EV multiple provides better results than traditional profitability ratios like the return on invested capital (ROIC).
Although not commonly used, the EBIT/EV multiple allows investors to compare companies with different tax rates and different levels of debt. EBIT/EV multiple normalizes the effect of dissimilar capital structure; hence, companies with different capital structures can be put on an equal base for comparison of earnings yields.
Furthermore, the use of EBIT instead of net income as a profitability measure eliminates the distorting effects of tax rate benefits. The enterprise value takes into consideration the debt value and market capitalization. Thus, it rewards the companies carrying less debt and high cash and disapproves of the companies with less cash and high debt.
However, EBIT/EV multiple cannot normalize the cost for depreciation and amortization. When companies use different accounting methods for fixed assets, it may result in misinterpretation of earnings yields.
Related Readings
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