Methods for Evaluating Company Valuation and Performance - Legal Counsel Guides 15
Eduard Grigoryan
International Legal Counsel (PQE 7) | Ph.D. in Law Candidate | LL.M. in International Private Law | SQE Candidate
1. EBITDA (Operational Performance Evaluation)
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It is a financial metric used to evaluate a company's operational performance without factoring in financial and accounting decisions such as interest payments, tax environments, and non-cash expenses. Here's a comprehensive breakdown of what EBITDA entails:
Definition and Components:
Purpose of EBITDA:
Operational Performance Indicator: EBITDA focuses on a company's core profitability by excluding non-operational factors like financing and accounting decisions. It gives a clearer picture of how a company’s core operations are performing.
Comparative Metric: It is often used to compare the profitability of companies within the same industry, especially when those companies have different tax structures, levels of debt, or capital expenditure requirements.
Cash Flow Proxy: Although not a perfect substitute, EBITDA is sometimes used as a rough estimate of cash flow, as it excludes non-cash expenses like depreciation and amortization.
EBITDA Formula:
EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
Alternatively, it can also be derived from operating income (EBIT) plus depreciation and amortization:
EBITDA = Operating Income (EBIT) + Depreciation + Amortization
2. Earnings Before Interest and Taxes (EBIT) (Operational Performance Evaluation)
Definition: Also known as Operating Income, EBIT is the company's profit before interest and tax expenses are deducted. Unlike EBITDA, EBIT includes depreciation and amortization, making it a more conservative measure of profitability.
Purpose: EBIT reflects how well a company is performing from its core operations, considering non-cash expenses like depreciation, which are important for capital-intensive industries.
Formula:
EBIT = Net Income + Interest + Taxes
Use Case: Useful for evaluating companies in industries where capital expenditures and depreciation are significant. EBIT also reflects the company's ability to manage its operations and cost structure.
3. Net Income (Profitability Assessment)
Definition: Also known as the bottom line, net income is the total profit of a company after all expenses, taxes, interest, depreciation, and amortization have been deducted.
Purpose: Net income provides a complete picture of a company’s profitability, including all financial, tax, and operational activities.
Formula:
Net Income = Total Revenue − Total Expenses
Use Case: Used by investors to understand the company's overall profitability and by management to gauge performance against targets.
4. Free Cash Flow (FCF) (Cash Flow and Liquidity Analysis)
Definition: Free Cash Flow is the cash generated by a company after accounting for capital expenditures needed to maintain or expand its asset base.
Purpose: FCF shows how much cash is available to the company for dividend payments, debt repayment, or reinvestment in the business.
Formula:
Free Cash Flow = Operating Cash Flow − Capital Expenditures (CapEx)
Use Case: Used by investors and analysts to assess a company’s ability to generate cash that can be returned to shareholders or reinvested.
5. Operating Cash Flow (OCF) (Cash Flow and Liquidity Analysis)
Definition: OCF measures the cash generated by a company's regular business operations, excluding capital expenditures, financing, and investing activities.
Purpose: Operating Cash Flow indicates a company’s ability to generate enough cash from its core operations to maintain or grow the business.
Formula:
Operating Cash Flow = Net Income + Non-Cash Expenses (e.g., Depreciation) + Changes in Working Capital
Use Case: OCF is critical for understanding a company’s liquidity and ability to sustain operations without external financing.
6. Return on Equity (ROE) (Efficiency and Return on Investment)
Definition: ROE measures the profitability of a company in relation to the equity invested by shareholders.
Purpose: ROE indicates how effectively a company is using its equity base to generate profit.
Formula:
ROE = Net Income / Shareholder’s Equity
Use Case: A key measure for investors assessing the efficiency with which a company uses equity to generate earnings.
7. Return on Assets (ROA) (Efficiency and Return on Investment)
Definition: ROA measures how efficiently a company is using its assets to generate profit.
Purpose: ROA provides insight into the company's ability to convert its investments in assets into net income.
Formula:
ROA = Net Income / Total Assets
Use Case: Used to assess the efficiency of asset utilization in generating profits, especially important for asset-heavy industries.
8. Debt-to-Equity Ratio (D/E) (Leverage and Risk Assessment)
Definition: The debt-to-equity ratio compares a company’s total liabilities to its shareholder equity, indicating the proportion of financing that comes from debt versus equity.
Purpose: The D/E ratio helps assess a company's financial leverage and risk profile.
Formula:
Debt-to-Equity = Total Liabilities / Shareholder’s Equity
Use Case: Investors and creditors use this ratio to evaluate the company’s risk level, particularly in terms of its ability to meet long-term obligations.
9. Price-to-Earnings Ratio (P/E) (Valuation and Investment Decisions)
Definition: The P/E ratio compares a company’s stock price to its earnings per share (EPS), reflecting how much investors are willing to pay for each dollar of earnings.
Purpose: P/E is a key valuation metric used to assess whether a stock is overvalued or undervalued relative to its earnings.
Formula:
P/E Ratio = Market Price per Share / Earnings per Share (EPS)
Recommended by LinkedIn
Use Case: Widely used by investors to compare valuation levels across companies or sectors.
10. Price-to-Book Ratio (P/B) (Valuation and Investment Decisions)
Definition: The Price-to-Book ratio compares a company’s market value to its book value (assets minus liabilities).
Purpose: P/B helps determine if a stock is undervalued or overvalued based on the company's net asset value.
Formula:
P/B Ratio = Market Price per Share / Book Value per Share
Use Case: Often used by value investors to find companies trading below their intrinsic value.
11. Interest Coverage Ratio (Leverage and Risk Assessment)
The Interest Coverage Ratio measures a company's ability to meet its interest obligations on outstanding debt. It is calculated by dividing EBIT (Earnings Before Interest and Taxes) by the company's interest expenses. A higher ratio indicates better financial stability, as it shows that the company generates enough earnings to comfortably cover its interest payments. Conversely, a low ratio may suggest potential financial difficulties in meeting debt obligations.
Formula:
Interest Coverage Ratio = EBIT / Interest Expense
Purpose:
Financial Stability: Helps assess a company’s risk of defaulting on debt payments.
Debt Management: Used by lenders and investors to evaluate the safety of extending credit to a company.
12. Gross Profit Margin (Profitability Assessment)
Definition: Gross profit margin measures the percentage of revenue that exceeds the cost of goods sold (COGS), indicating the efficiency of production processes.
Purpose: Gross margin provides insight into a company’s core profitability before accounting for operating expenses.
Formula:
Gross Profit Margin = (Gross Profit / Revenue) ×100
Use Case: Used to evaluate the profitability of a company’s products or services, especially in relation to production efficiency.
13. Operating Margin (Profitability Assessment)
Definition: Operating margin measures the percentage of revenue that remains after covering operating expenses (excluding interest and taxes).
Purpose: It indicates how efficiently a company is managing its operations.
Formula:
Operating Margin = (Operating Income (EBIT) / Revenue) × 100
Use Case: Analysts use operating margin to assess a company’s ability to generate profit from its core business activities.
14. Enterprise Value (EV) (Valuation and Investment Decisions)
Definition: Enterprise Value is a measure of a company’s total value, taking into account market capitalization, debt, and cash.
Purpose: EV is a comprehensive valuation metric that represents the theoretical takeover price of a company.
Formula:
EV = Market Capitalization + Total Debt − Cash and Cash Equivalents
Use Case: Often used in valuation ratios like EV/EBITDA to assess a company’s total value in relation to its earnings.
15. EV/EBITDA Ratio (Comparison Across Companies)
Definition: The EV/EBITDA ratio compares a company's enterprise value (EV) to its EBITDA. It’s a commonly used valuation multiple.
Purpose: EV/EBITDA is useful for comparing the valuation of companies with different capital structures, as it neutralizes the effects of varying debt levels.
Formula:
EV/EBITDA = Enterprise Value / EBITDA
Use Case: This ratio is used to assess whether a company is overvalued or undervalued relative to its peers based on its operational earnings.
16. Return on Invested Capital (ROIC) (Efficiency and Return on Investment)
Definition: ROIC measures how efficiently a company uses its invested capital (debt and equity) to generate profit.
Purpose: ROIC indicates how well a company is using its capital to create value for shareholders.
Formula:
ROIC = Net Operating Profit After Taxes (NOPAT) / Invested Capital
Use Case: Investors use ROIC to assess a company's effectiveness at allocating capital to profitable investments.
17. Dividend Yield (Income Generation)
Definition: The dividend yield measures the annual dividend payment relative to the stock price, representing the return on investment from dividends.
Purpose: It provides insight into the income generated by owning a stock, relative to its price.
Formula:
Dividend Yield = (Annual Dividend per Share / Price per Share) × 100
Use Case: Important for income-focused investors who prioritize dividend returns over capital gains.
Each financial metric offers a different perspective on a company's performance. While EBITDA focuses on operational earnings, other methods such as net income, free cash flow, and return ratios provide a more comprehensive understanding of profitability, efficiency, liquidity, and valuation. Depending on the industry, stage of the business, and the specific analysis required, different metrics will be more or less relevant.
Subscribe to my other thematic newsletters: