Why do analysts choose EV/EBITDA over EV/EBIT?

Earnings multiples are the most trusted weapons in a valuation analyst's arsenal. They form a basis for comparing the value of companies based on their financial health and market value. 

Among the various earnings multiples used in valuations, EV/EBITDA (enterprise value to earnings before interest, taxes, depreciation, and amortization ratio) and EV/EBIT (enterprise value to earnings before interest and taxes ratio) are the most prominent ones.

Here, we will explore why EV/EBITDA is often considered better than EV/EBIT through a theoretical discussion and examination of examples.

Why EV/EBITDA over EV/EBIT?

These two metrics provide valuable insights into a company’s operational efficiency and profitability. Although both metrics play an important role in financial analysis, a growing number of analysts prefer EV/EBITDA over EV/EBIT.

While EV/EBITDA and EV/EBIT have their uses, EV/EBITDA's performance stems from its ability to provide a more neutral and standardized measure of a company's operational performance. It is also useful for comparative analysis and M&A activities.

Here are a few reasons why EBITDA is analysts' choice,

Here, we are adding an example to understand the situation more:

Company A:

Market Capitalization: $100 million

Total Debt: $50 million

Cash and Cash Equivalents: $10 million

Operating Income (EBIT): $20 million

Depreciation and amortization: $5 million

Company B:

Market Capitalization: $100 million

Total Debt: $50 million

Cash and Cash Equivalents: $10 million

Operating Income (EBIT): $20 million

Depreciation and amortization: $10 million

Calculation:

Enterprise Value (EV) for Companies A and B:

EV = Market Capitalization + Total Debt - Cash and Cash Equivalents

EV $100 million + $50 million - $10 million = $140 million

EBIT:

Company A: $20 million 

Company B: $20 million

EV/EBIT:

Company A: $140 million/$20 million = 7

Company B: $140 million/$20 million = 7

EBITDA:

EBITDA = EBIT + Depreciation + Amortization

Company A: $20 million + $5 million = $25 million

Company B: $20 million + $10 million = $30 million

EV/EBITDA:

Company A: $140 million/$25 million = 5.6

Company B: $140 million/$30 million = 4.67

Summary:

Company A:

EV/EBIT: 7

EV/EBITDA: 5.6

Company B:

EV/EBIT: 7

EV/EBITDA: 4.67

Analysis:

• EV/EBIT: It can be ascertained that the two firms have an identical EV/EBIT of 7. This is a shortcoming of this ratio because it does not factor in the disparity of depreciation and amortization, which may leave out otherwise crucial value data in the two companies.
• EV/EBITDA: The analysis of Company A based on its EV/EBITDA ratio gives 5.6. Company A's number is higher than Company B's, which has a lower EV/EBITDA ratio of 4.67. This suggests that Company B is more valuable to investors than Company A because it yields higher EBITDA in relation to its enterprise value compared to Company A, even though it has the same level of EBIT.

From the above Scenario, we can point out why analysts choose EV/EBITDA over EV/EBIT. 

Read more about EBITDA here.

Get a comprehensive view of the company through EBITDA.

Both EBIT and EBITDA measure the profitability of a company's core business operations. However, financial analysts commonly favor the EV/EBITDA metric over EBIT due to its ability to offer a consistent, comprehensive, and cash-flow-centric evaluation of a company's operational performance. This preference stems from the metric's facilitation of comparisons across diverse industries and accounting methodologies.

 It is best left to the professionals to apply the right combination of valuation metrics to arrive at a reliable investment decision. The Eqvista valuation team is an expert at this. For more information, reach us today.