RELATIVE VALUATION – NOTES, CASES AND

EXAMPLES
PREPARED BY RAHUL KRISHNA
Valuation multiples are the quickest way to value a company, and are useful in
comparing similar companies (comparable company analysis). They attempt to
capture many of a firm's operating and financial characteristics (e.g. expected
growth) in a single number that can be mutiplied by some financial metric
(e.g. EBITDA) to yield an enterprise or equity value. Multiples are expressed as a
ratio of capital investment to a financial metric attributable to providers of that
capital.

Exhibit A – Common Valuation Multiples

Enterprise Value Multiples Equity Value Multiples

EV / EBITDA Price / EPS ("P/E")

EV / EBIT Equity Value / Book Value
EV / Sales P / E / Growth ("PEG Ratio")
EV / Unlevered Free Cash Flow

One very important point to note about multiples is the connection between the
numerator and denominator. Since enterprise value (EV) equals equity value plus
net debt, EV multiples are calculated using denominators relevant to all stakeholders
(both stock and debt holders). Therefore, the relevant denominator must be
computed before interest expense, preferred dividends, and minority interest
expense. On the other hand, equity value multiples are calculated using
denominators relevant to equity holders, only. Therefore, the relevant denominator
must be computed after interest, preferred dividends, and minority interest expense.

For example, an EV/Net Income multiple is meaningless because the numerator

applies to shareholders and creditors, but the denominator accrues only to
shareholders. Similarly, an Equity Value/EBITDA multiple is meaningless because
the numerator applies only to shareholders, while the denominator accrues to all
holders of capital. With this understanding of the relationship between numerator
and denominator, we can invent virtually any multiple we like to value a business,
so long as the multiple is, of course, relevant to that business.

The choice of multiple(s) in valuing and comparing companies depends on the nature
of the business or the industry in which the business operates. For example,
EV/(EBITDA−CapEx) multiples are often used to value capital intensive businesses
like cable companies, but would be inappropriate for consulting firms. To figure out
which multiples apply to a business you are considering, try looking at equity
research reports of comparable companies to see what analysts are using.

Enterprise value multiples are better than equity value multiples because the former
allow for direct comparison of different firms, regardless of capital structure. Recall,
that the value of a firm is theoretically independent of capital structure. Equity value
multiples, on the other hand, are influenced by leverage. For example, highly levered
firms generally have higher P/E multiples because their expected returns on equity
are higher. Additionally, EV multiples are typically less affected by accounting
differences, since the denominator is computed higher up on the income statement.

In practice, we generally refer to some multiples using the denominator only,

because the numerator is implied. For example, when talking about the EV/EBITDA
multiple, we would simply say "EBITDA multiple", because the only sensible
numerator is EV.

Exhibit B – Comments on Various Multiples

Multiple Comments

EV / EV/EBITDA is one of the most commonly used valuation metrics, as

EBITDA EBITDA is commonly used as a proxy for cash flow available to the
firm. EV/EBITDA is often in the range of 6.0x to 18.0x.

EV / When depreciation and amortization expenses are small, as in the case

EBIT of a non-capital-intensive company such as a consulting firm, EV/EBIT
and EV/EBITDA will be similar. Unlike EBITDA, EBIT recognizes that
depreciation and amortization, while non-cash charges, reflect real
expenses associated with the utilization and wear of a firm's assets that
 will ultimately need to be replaced. EV/EBIT is often in the range of
10.0x to 25.0x.

EV / Sales When a company has negative EBITDA, the EV/EBITDA and EV/EBIT
multiples will not be material. In such cases, EV/Sales may be the most
appropriate multiple to use. EV/Sales is commonly used in the valuation
of companies whose operating costs still exceed revenues, as might be
the case with nascent Internet firms, for example. However, revenue is a
poor metric by which to compare firms, since two firms with identical
revenues may have wildly different margins. EV/Sales multiples are
often in the range of 1.00x to 3.00x

P/E P/E is one of the most commonly used valuation metrics, where the
numerator is the price of the stock and the denominator is EPS. Note that
the P/E multiple equals the ratio of equity value to net Income, in which
the numerator and denominator are both are divided by the number of
fully diluted shares. EPS figures may be either as-reported or adjusted
as described below. P/E multiples are often in the range of 15.0x to
30.0x.

P/E/G The PEG ratio is simply the P/E ratio divided by the expected EPS
growth rate, and is often in the range of 0.50x to 3.00x. PEG ratios are
more flexible than other ratios in that they allow the expected level of
growth to vary across companies, making it easier to make comparisons
between companies in different stages of their life cycles. There is no
standard time frame for measuring expected EPS growth, but
practitioners typically use a long-term, or 5-year, growth rate.

Calculating the Denominator (EBITDA, Net Income, etc.)

The denominator may be either a stock or a flow. A stock is measured at a single

point in time (e.g. book value), while a flow is measured over a period of time (e.g.
EBITDA). We will focus our discussion here on flows.

Historical valuation multiples are usually calculated over the last twelve month
(LTM) period. To calculate the LTM EBITDA, for example, add the EBITDA from
the most recent stub period to the latest full-year EBITDA, and subtract the EBITDA
from the corresponding stub period last year. Publicly traded U.S. companies report
earnings on a quarterly basis, but many publicly traded foreign firms only report
earnings every 6 months on a semi-annual basis. Therefore, it is possible that the
LTM periods for some foreign firms will not chronologically align with the LTM
periods for U.S. firms.

Example – LTM Calculation

A company's latest 10-K reported EBIT of $100 for the fiscal year ending 12/31/07.
The company's latest 10-Q reported EBIT of $80 for the nine months ended 9/30/08
and $70 for the nine months ended 9/30/07. What is the company's LTM EBIT?

LTM EBIT = $100 + $80 − $70 = $110.

Most publicly traded companies are valued based on their projected, rather than
historical, earnings and cash flows. Projections, or forward estimates, are made by
equity research analyst estimates, and often averaged for use in calculating valuation
multiples. Forward estimates can be obtained from sources like Bloomberg, First
Call, and IBES. These projections are usually provided on a calendar year basis for
consistency, but it is necessary to verify that all such estimates use the same yearly
basis (either calendar or fiscal) to make apples-to-apples comparisons.

Adjust the denominator to exclude the effects of extraordinary and non-recurring

items such as restructuring charges, one-time gains/losses, accounting changes, legal
settlements, discontinued operations, and asset impairment charges. Also, if
noncontrolling interest is excluded from the calculation of EV, the portion of
EBITDA and EBIT attributable to the noncontrolling interest should also be
excluded from the denominator.

When using multiples to compare similar companies in a peer group as part of

a comparable companies analysis, it is necessary to ensure that the comparison is
"apples-to-apples". This means that the denominators of all multiples compared
should span the same time period, whether historical or projected, and be adjusted
for the same items, such as stock-based compensation.

Adjusted Earnings
Not all earnings are created equal, as equity research analysts may use either reported
earnings or adjusted cash earnings in the calculation of EPS. Adjusted earnings
figures often add back non-cash expenses like stock-based compensation,
amortization, restructuring charges. When comparing the P/E ratios of different
companies, it is very important to be sure that the ratios you are comparing all use
either as-reported or cash EPS figures to make an apples-to-apples comparison.

Analysts will often use adjusted EPS figures when adjusted earnings are made
available by the company. To see if the company releases adjusted results, check the
8-K filing concerning the most recent earnings release. Then, compare the analyst's
figures with reported and adjusted results to determine which is used by the analyst.
The analyst's numbers may not match either set of figures, but should be close
enough to indicate which set he or she is using.

Unlevered Free Cash Flow

Unlevered free cash flow (UFCF) is the free cash flow attributable to all suppliers
of capital (shareholders and debt holders). To calculate UFCF, start with operating
income (EBIT). Note that EBIT is an unlevered figure because it is
calculated before interest expense. Next, subtract taxes to yield EBIAT
[=EBIT×(1−tax rate)]. Then, add back depreciation expense and subtract CapEx and
the change in net working capital (NWC).

Forward-Looking vs. Historical Multiples

Empirical evidence shows that forward-looking multiples are more accurate

predictors of value than historical multiples.

Differences between Trailing PE vs

Forward PE Ratio
Trailing PE uses earnings per share of the company over the period of the
previous 12 months for calculating the price-earnings ratio whereas Forward PE
uses the forecasted earnings per share of the company over the period of the
next 12 months for calculating the price-earnings ratio.

What is Trailing PE Ratio

Trailing PE Ratio is where we use the Historical Earning Per share in the
denominator.

Trailing PE Ratio Formula (TTM or Trailing Twelve Months) = Price Per

Share / EPS over the previous 12 months.

Trailing PE Ratio Example

Let us calculate the Trailing PE Ratio of Amazon.

Amazon Current Share Price = 1,586.51 (as of 20th March, 2018)

source: reuters.com

 Earnings Per Share (TTM) of Amazon = EPS (Dec,2017) + EPS (Sep 2017)
+ EPS (June 2017) + EPS (March, 2017) = 2.153 + 0.518 + 0.400 + 1.505
= $4.576
 PE (TTM) = Current Price / EPS (TTM) = 1586.51 / 4.576 = 346.7x
What is Forward PE Ratio
Let us now look at what Forward PE Ratio Formula is –

Forward PE Ratio Formula = Price Per Share / Forecasted EPS over the next 12
months

Forward PE Ratio Example

Amazon Current Share Price = 1,586.51 (as of 20th March 2018)

Forward EPS (2018) of Amazon = $8.31

Forward EPS (2019) of Amazon = $15.39

 Forward PE Ratio (2018) = Current Price / EPS (2018) = 1,586.51/8.31 =

190.91x
 Forward PE Ratio (2019) = Current Price / EPS (2019) = 1,586.51/15.39 =
103.08x

Trailing PE vs Forward PE Ratio

As you can note from above, the key difference between the two is the EPS
used. For Trailing PE, we use the historical EPS, whereas, for Forward PE, we use
EPS forecasts.

Trailing PE vs Forward PE Ratio Example

Trailing PE Ratio uses the Historical EPS, while Forward PE Ratio uses the
Forecast EPS. Let us look at the below another example to calculate the Trailing
PE vs forwarding PE Ratio.

Company AAA, Trailing Twelve Months EPS is $10.0 and its Current Market Price
is $234.

 Trailing Price Earning Ratio formula = $234 / $10 = $23.4x

Likewise, let us calculate the Forward Price Earning Ratio of Company AAA.
Company AAA 2016 estimated EPS is $11.0 and its current price is $234.

 Forward Price Earning Ratio formula = $234 / $11 = $21.3x

Trailing PE vs Forward PE Ratio (Important points
to note)
Some of the things to consider regarding the Trailing Price Earning Ratio
vs Forward Price Earning Ratio.

 If EPS is expected to grow then the Forward PE Ratio will be lower than
the Historical or Trailing PE. From the above table, AAA and BBB show an
increase in EPS and hence, their Forward PE Ratio is lower than the Trailing
PE Ratio.
 On the other hand, if EPS is expected to decrease, then you will note that
the Forward PE Ratio will be higher than the Trailing PE Ratio. This can be
observed in Company DDD, whose Trailing PE Ratio was at 23.0x,
however, Forward PE Ratio increased to 28.7x and 38.3x in 2016 and 2017,
respectively,
 Please note that the Forward PE Ratio only factors forecast EPS (2016E,
2017E and so on), whereas the stock price will reflect earnings growth
prospects far into the future.
 One should not only compare the Trailing PE Ratio for valuation
comparison between the two companies but also look at the Forward PE
Ratio to focus on Relative Value – whether the PE differences reflect
company’s long-term growth prospects and financial stability.

Key Observations

 It can be noted that the P/B ratio is generally higher for software
companies. We note that for the above companies price to book value
ratio is higher than 4-5x.
 The primary reason for the higher P/B Ratio is low tangible assets as
compared to the total assets.
 o The value derived from above may not the be correct number to
look at.nternet and software companies have a higher amount of
intangible assets and therefore the Book
 (as seen in the Microsoft Balance Sheet)
 Please note that due to this reason we do not use the Price to Book Value ratio
as a valuation ratio for companies that have a low amount of tangible assets.
 Additionally, these companies are high growth companies in most cases,
where we can apply alternate measures like PE ratio or PEG ratio to
incorporate growth during valuations.

Other sectors where you will find higher Price to Book value ratio and
CANNOT apply P/B Ratio

 Internet Companies like Amazon, JD.com, Google, Alibaba, eBay

 FMCG Companies like Colgate, P&G, Walmart, Cadbury, Coca-cola

Other capital-intensive sectors where PB can be used as a proxy valuation tool.

 Industrial Firms like Siemens, General Electric, BASF, Bosch, etc

 Oil and Gas Companies like PetroChina, Sinopec, Exxon Mobil, Royal Dutch Shell, BP,
etc.

Why P/B Ratio is used in Banking?

From above, we have noted that P/B ratios cannot be applied to Internet and
software companies, however, we can still use these ratios as a proxy for capital
intensive companies like automobiles and Oil & Gas. Let us now look at if Price
to book value makes sense for Financial Sectors.

Let us look at the Balance Sheet of Citigroup. You may download Citigroups 10K
report from here.
Key Observation of Citigroup’s Balance Sheet

 Banks have assets and liabilities which are periodically marked to market,
as it is mandatory under regulations. So, the Balance Sheet value
represents the market value, unlike other industries where the Balance
Sheet represents the historical cost of the assets/liabilities.
 Bank assets include investments in government bonds, high-grade
corporate bonds or municipal bonds, along with commercial, mortgage,
or personal loans that are generally expected to be collectible.

The below graph shows a quick comparison of the Historical Book values
of JPMorgan, UBS, Citigroup, and Morgan Stanley.
source: ycharts

Why Price to Book Value ratio can be used to value Banking

Stocks

 Since Banking Assets and Liabilities are periodically marked to market,

their assets and liabilities represent the fair or the market value. Hence,
P/B ratio can be used for valuing Banking Stocks.
  Under ideal conditions, the price/book value (P/BV) ratio should be close
to 1, though it would not be surprising to find a P/BV ratio of less than
one for a bank with a large amount of Non Performing Assets.
 It is also possible to find a P/BV ratio above 1 for a bank with significant
growth opportunities due to, say, its location, because it is a desirable
merger candidate, or because of its use of technology in banking.

Historical P/B ratio vs Forward P/B

Like the Trailing PE and the Forward PE, we can have a similar formula for Price
to Book Value.

Historical P/B = Current Price / Book Value (historical)

Forward P/B = Current Price / Book Value (Forward, forecast)

The price to book value of history is relatively straightforward to find out from
the balance sheet. However, the forward Book Values might get slightly tricky.

There are two things that you can do to obtain the book value –

 The easier (and expensive) way is to get access to Factiva or Bloomberg

where we get such data in an easily downloadable format. You just need
to provide the ticker and download consensus book to value forecast
 The difficult one is to prepare the financial model and project Balance
Sheet of the company under consideration. It involves preparing a full
three statement financial model.

 Let us take an example to see how we can incorporate Trailing and

Forward Price to Book Value ratio to identify the cheapest and most
expensive stock from the consideration set.
Calculate the historical PB and Forward PB
AAA Bank, Historical Book Value is $500.0 and its Current Market Price is $234.

Trailing P/B Ratio = $234 / $500 = 0.5x

Likewise, we can calculate Forward Price to Book Value ratio of AAA Bank. AAA
2016 estimated Book Value is $400.0 and its current price is $234.

Forward P/B Ratio = $234 / $400 = $0.6x

Some of the things to consider regarding the Historical and Forward Price
to Book Value Ratio

 If Book Value is expected to increase, then the Forward P/B ratio will be
lower than the Historical Ratios. We can observe this in the case of BBB
Bank and CCC Bank where the Book Value forecast increases in 2016 and
2017.
 However, if Book Value is expected to show a decline in the future, then
you will note that the Forward P/B ratio will be higher than the Historical
P/B Ratio. This can be observed in Bank AAA and Bank EEE, where the
Book value declines each year.
  There can also be a case where book value does not show any trend. For
example, Bank DDD, where we see that Book value increases in 2016 and
thereby decreases in 2017. In such cases, we will not see any particular
trend in the Price to Book Value Ratio.

Relationship between P/B Ratio and ROE

The price to book value ratio is closely related to the ROE of the company.

(Price/Book Value Per share) = (Price/EPS) x (EPS/Book Value Per share)

Now, Price/EPS is nothing but PE ratio.

EPS/Book value per share formula is ROE (remember, ROE = Net Income / Shareholder’s
Equity or Book Value)

Because of its close linkage to return on equity (price to book is PE multiplied by ROE), it is useful
to view price to book value together with ROE

 General Rule of Thumb

o Overvalued: Low ROE + High P/BV Ratio
o Undervalued: High ROE + Low P/BV Ratio

Applicable to those industries which need to revalue their balance sheet assets every year. Used in
valuing Financials, especially banks, which squeeze a small spread from a large base of assets
(loans) and multiply that spread by utilizing high levels of leverage (deposits)

Limitation
 Book value only takes into consideration the tangible value of the firm. Intangible economic assets
like human capital are not taken into account in the P/B Ratio.
 Effect of technology upgrades, Intellectual Property, Inflation, etc can cause the book and market
values of assets to differ significantly
 Accounting Policies adopted by the management can have a significant impact on the Book
Value. For example, Straight-line method vs Accelerated depreciation method can change the Net
Property Plant and equipment value drastically.
  Additionally, the Business model can also lead to differences in Book Value. A company that
outsources production will have a lower book value of assets as compared to a company that
produces goods in-house.

What is PEG Ratio Formula?

The term “PEG ratio” or Price/Earnings to Growth ratio refers to the stock
valuation method based on the growth potential of the company’s earnings.
The formula for PEG ratio is derived by dividing the stock’s price-to-
earnings (P/E) ratio by the growth rate of its earnings for a specified time period.

PEG Ratio Formula can be expressed as below,

PEG Ratio Formula = P/E Ratio / Earnings Growth Rate

where,

P/E ratio = Stock Price / Earnings per share

There are two methods of calculating the PEG ratio and they are:

 Forward PEG
 Trailing PEG

Forward PEG: In this method, the earnings growth rate is determined on the
basis of annualized future growth rate for a certain period of time, usually a
period of up to five years.

Trailing PEG: In this method, the earnings growth rate is determined on the
basis of the stock’s trailing growth rates. The sources of such growth rate could
be from the previous 12 months, last fiscal year or some sort of multiple-year
historical average.
Explanation
The PEG ratio formula calculation is simply done by using the following four
steps:

Step 1: Firstly, determine the current price of the company stock from the stock
market.

Step 2: Next, determine the net income of the company from the income
statement. Then, figure out the portion of the profit going to the shareholders
after deduction of preference dividends. Now, divide the portion of the net
income by the outstanding no. of shares to arrive at the earnings per share or
EPS.

EPS = (Net income – Preference dividends) / No. of outstanding equity

shares

Step 3: Next, divide the current stock price of the company by its earnings per
share to calculate the P/E ratio.

Step 4: Next, determine the future earnings growth rate based on the financial
projection of the company as per forwarding PEG ratio method. The financial
projection is prepared on the basis of the company-specific plans and future
growth potential of the industry and market overall. On the other hand, the PEG
ratio can be derived by using the past performance of the company as per the
Trailing PEG ratio.

Step 5: Finally, the formula for PEG ratio calculation is derived by dividing the
P/E ratio by the growth rate of its earnings for a specified time period as shown
below.
PEG ratio = P/E ratio / Earnings growth rate

Let us take the example of company ABZ Ltd which is in the business of
manufacturing mobile phones. The company has witnessed a tremendous
change in the market potential with the launch of its new product and as
such the future growth is expected to be higher than the past. The stock
of the company is currently trading at $65 per share.

Below is given data for calculation of forward PEG ratio and a trailing PEG ratio
of company ABZ Ltd

P/E Ratio

Therefore, the calculation of P/E ratio will be as follows

P/E ratio = Current price / EPS for FY18 = $65 / $3.61

P/E Ratio= 18.00

Trailing Earnings Growth Rate

Therefore, the Earnings growth rate for trailing five years can be calculated as,

The earnings growth rate for trailing five years = (EPS for FY18 / EPS for FY14) 1/4 –
1

= ($3.610 / $3.000)1/4 – 1
Trailing Earnings Growth Rate = 4.74%

Trailing PEG Ratio

Therefore, the calculation of Trailing PEG ratio will be as follows,

Trailing PEG ratio = 18.00 / 4.74

Trailing PEG Ratio= 3.80

Forward Earnings Growth Rate

Therefore, the calculation of Earnings growth rate for the future five years will
be as follows

The Earnings growth rate for future five years = (EPS for FY23P / EPS for FY18) 1/5 –
1

=($6.078 / $3.610)1/5 – 1

Forward Earnings Growth Rate = 10.98%

Forward PEG Ratio

Therefore, the calculation of Forward PEG ratio will be as follows,

Therefore, Forward PEG ratio = 18.00 / 10.98

Forward PEG Ratio= 1.64

Therefore, it can be seen that the PEG ratio is expected to improve in the coming
years which is a good indication for the company.

What is EV to EBITDA?
EV to EBITDA Multiple is an important valuation metric used for measuring
the value of the company with an objective of comparing its valuation with
similar stocks in the sector and it is calculated by dividing enterprise
value (Current Market Cap + Debt + Minority Interest + preferred shares –
cash) by EBITDA (earnings before interest, taxes, depreciation and
amortization) of the company.
I rate this multiple above PE Ratio! The values of EV and EBITDA are used in
order to find the EV/EBITDA ratio of an organization and this metric is widely
used to analyze and measure an organization’s ROI i.e. return of investment as
well as its value.
We note that EV to EBITDA Multiple of Amazon is at around 29.6x whereas for
WalMart, it is around 7.6x. Does this mean that WallMart is trading cheap
and we should buy Walmart compared to Amazon?

What is Enterprise Value?

Enterprise Value, or EV, shows a company’s total valuation. EV is used as a better
alternative to market capitalization. The value calculated as the Enterprise
Value is considered better than market capitalization because it is calculated by
adding more vital components to the value of market capitalization. The added
components used in the EV calculation are debt, preferred interest, minority
interest, and total cash and cash equivalents. The values of the debt, minority
interest, and preferred interest are added with the calculated market
capitalization value, while the total cash and cash equivalents are subtracted
from the calculated value to get the Enterprise Value (EV).

We can thus write a basic formula for calculating the EV as follows:

EV = Market Cap + Debt + Minority Interest + Preference Shares – Cash &

Cash Equivalents.

Theoretically, the calculated enterprise value can be considered as the price or

value at which the company is bought by an investor. In such a case, the buyer
will have to take up the debt of the organization too as his responsibility. In
other words, it is said that the particular value will be pocketed by him too.

The inclusion of debt is something that gives the Enterprise Value its added
advantage for the purpose of organization value representation. This is because
the debt is to be considered seriously when it comes to any takeover situation.

For example, it will be more profitable to acquire an organization with a market

capitalization of say $10 million with no debt than acquiring an organization
with the same market capitalization and a debt of $5 million. Apart from the
debt, the enterprise value calculations also include other special components
that are important in arriving at an accurate figure for the firm’s value.

Also, you can have a look at the key differences between Enterprise Value vs
Market Capitalization

Understanding EBITDA
EBITDA or earnings before interest, taxes, depreciation, and amortization is a
measure used to get a representation of an organization’s financial
performance. With the help of this, we can find out the potential of a particular
firm in terms of the profit its operations can make.

We can write the formula for EBITDA in simple terms as follows:

EBITDA = Operating Profit + Depreciation + Amortization

Here, the operating profit is equal to the net profit, interest, and taxes added
together. The depreciation expense and amortization expense play a major role
in EBITDA calculation. So in order to understand the term EBITDA to the fullest,
these two terms are explained in brief below:

 Depreciation: Depreciation is an accounting technique for allocating the

cost of a tangible asset over its useful life. Businesses depreciate their
long-term assets for both, tax and accounting purposes. For tax
purposes, businesses deduct the cost of the tangible assets they purchase
as business expenses. But, businesses should depreciate these assets in
accordance with IRS rules regarding how and when the deduction could
be done.
 Amortization: Amortization can be explained as the paying off of debt
with a fixed repayment schedule, in regular installments, over a particular
amount of time. Two common examples of this are a mortgage and an
automobile loan. It additionally refers to the spreading out of capital
expenses for intangible assets, over a particular period of time, again for
accounting and tax purposes.

EBITDA is actually net income with interest, taxes, depreciation, and

amortization further added back to it. EBITDA may be employed to analyze and
compare the profitability of different organizations and industries as it
eliminates the effects of financing and accounting decisions. EBITDA is
commonly utilized in valuation ratios and compared to enterprise worth and
revenue.
EBITDA is a Non-GAAP measure and is reported and used internally to measure
the performance of the company.

source: Vodafone.com

EV to EBITDA ratio or the Enterprise Multiple

Now that we know about EV and EBITDA, we can look at how they are used to
get the EV/EBITDA ratio or in other words the Enterprise Multiple. The
EV/EBITDA ratio looks at a firm as a potential acquirer would, taking into
consideration the company’s debt, which alternative multiples, like the price-to-
earnings (P/E) ratio, don’t embrace.

This can be calculated by the following formula:

Enterprise value Formula = Enterprise Value / EBITDA

EV to EBITDA – Forward vs Trailing

EV to EBITDA can be further subdivided into Investment Banking Analysis.

 Trailing
 Forward

Trailing EV to EBITDA formula (TTM or Trailing Twelve Months) =

Enterprise Value / EBITDA over the previous 12 months.

Likewise the Forward EV to EBITDA formula = Enterprise Value / EBITDA

over the next 12 months.

The key difference here is the EBITDA (denominator). We use the historical
EBITDA in trailing EV to EBITDA and use forward or EBITDA forecast in the
forward EV to EBITDA.

Let us look at the example of Amazon. Amazon’s trailing multiple is at 29.58x,

however, its forward multiple is at around 22.76x.
source: ycharts

Calculating EV to EBITDA (Trailing & Forward)

Let us take the example from the below table and calculate Trailing and forward
EV/EBITDA. The table is a typical comparable table with relevant competitors
listed along with its financial metrics.

Let us calculated EV to EBITDA for Company BBB.

Enterprise Value Formula = Market Capitalization + Debt – Cash

Market Capitalization = Price x number of Shares

Market Capitalization (BBB) = 7 x 50 = $350 million

Enterprise Value (BBB) = 350 + 400 -100 = $650 million

Trailing Twelve Month EBITDA of BBB = $30

EV to EBITDA (TTM) = $650 / $30 = 21.7x

Likewise, if we want to find the forward multiple of BBB, we just need the EBITDA
forecasts.

EV to EBITDA (forward – 2017E) = Enterprise Value / EBITDA (2017E)

EV to EBITDA (forward) = $650 / 33 = 19.7x

Some of the points to consider with respect to Trailing EV to EBITDA vs Forward

EV to EBITDA.
  If EBITDA is expected to grow then the Forward multiple will be lower than
the Historical or Trailing multiple. From the above table, AAA and BBB
show an increase in EBITDA and hence, their Forward EV to EBITDA is
lower than the Trailing PE.
 On the other hand, if EBITDA is expected to decrease, then you will note
that the Forward EV to EBITDA multiple will be higher than the Trailing
multiple. This can be observed in Company DDD, whose Trailing EV to
EBITDA was at 21.0x, however, Forward EV to EBITDA increased to 26.3x
and 35.0x in 2017 and 2018, respectively,
 One should not only compare the Trailing multiple for valuation
comparison between the two companies but also look at the Forward
multiple to focus on Relative Value – whether the EV to EBITDA difference
reflects the company’s long-term growth prospects and financial stability.

How to Find Target Price using EV to EBITDA

Now that we know how to calculate EV to EBITDA, let us find the Target Price of
the stock using this EV to EBITDA multiple.

We revisit the same comparable comp table that we used in the earlier example.
We need to find the fair value of TTT that operates in the same sector as below.
We note that the average multiple of this sector is 42.2x (Trailing), 37.4x (forward
– 2017E) and 34.9x (forward – 2018E). We could directly use these multiples to
find the fair value of the Target Company (YYY).

However, we note that company FFF and GGG are outliers with EV to EBITDA
multiple ranges that are too high. These outliers have dramatically increased
the overall EV to EBITDA multiple in the sector. Using these averages will
lead to incorrect and higher valuations.

The right approach here would be to remove these outliers and recalculate EV
to EBITDA multiple. With this, we will remove any impact from these outliers
and a comparable table will be cohesive.
Recalculated average multiple of this sector are 19.2x (Trailing), 18.5x (forward
– 2017E) and 19.3x (forward – 2018E).

We can use these multiples to find the Target Price of YYY.

 EBITDA (YYY) is $50 million (ttm)

 EBITDA (YYY) is $60 million (2017E)
 Debt = $200 million
 Cash = $50 million
 Debt (2017E) = $175 million
 Cash (2017E) = $75 million
 Number of Shares is 100 million

Target Price (based on trailing multiple)

 Enterprise Value (YYY) = Sector Average x EBITDA (YYY)

 Enterprise Value (YYY) = 19.2 x 50 = $ 960.4 million.
 Equity Value = Enterprise Value – Debt + Cash
 Equity Value (YYY) = 960.4 – 200 + 50 = $ 810.4 million
 Fair Price x Number of Shares = $810.4
 Fair Price = 810.4/100 = $8.14

Target Price (based on forward multiple)

 Enterprise Value (YYY) = Sector Average x EBITDA (YYY)

 Enterprise Value (YYY) = 18.5 x 60 = $ 1109.9 million.
 Equity Value (2017E) = Enterprise Value – Debt (2017E) + Cash (2017E)
 Equity Value (YYY) = 1109.9 – 175 + 75 = $1009.9 million
 Fair Price x Number of Shares = $1009.9 million
 Fair Price = 1009.9 /100 = $10.09
Why EV to EBITDA is better than PE ratio?
EV to EBITDA is better in many ways that PE ratio.

#1 – PE ratios can be gamed by Accounting, however, Gaming

of EV to EBITDA is difficult!
This will become obvious with the help of an example.

There are two companies – AA and BB. We assume that both companies are
identical in all ways (Business, Revenue, clients, competitors). Though this is no
possible in the practical world, we assume this impractical assumption for the
sake of this example.

We also assume the following –

 Current Share Price of AA and BB = $40

 Number of Shares Outstanding of AA and BB = 100

In this case, you should not have any particular preference to buy a specific
stock as the valuations of both the companies should be the same.

Introducing a slight complication here! Though all parameters are equal, we

make an only change with respect to the depreciation policies used by each
company. AA follows Straight Line Depreciation Policy and BB follows accelerated
depreciation policy. Straight-line charges equal depreciation over the useful life.
Accelerated Deprecation policy charges higher depreciation in initial years and
lower depreciation in final years.

Let us see what happens to their valuations?

As noted above, the PE ratio of AA is 22.9x while PE ratio of BB is 38.1x. So
which one will you buy?

Given this information, we are inclined to favor AA as its PE multiple is lower.

However, our very assumption that these two companies are identical twins and
should command the same valuations is challenged because we used PE Ratio.
This is one of the biggest limitations of PE ratio.

This huge valuation problem is solved by EV to EBITDA.

Let us now look at the table below –

We note that the Enterprise value of AA and BB are the same (this is the core
assumption of our example). From the table above, we note that the enterprise
value is $4,400 million (for both).

Though PAT for AA and BB was different, we note that EBITDA is not affected
by the depreciation policy used. AA and BB have the same EBITDA of $400.

Calculating EV to EBITDA (AA & BB) $4400 / $400 = 11.0x

We note that EV/EBITDA of both AA and BB is the same at 11.0x and is in
consonance with our core assumption that both companies are the same.
Therefore it doesn’t matter which company you invest into!

#2 – Buybacks affect PE Ratio

PE ratio is inversely proportional to the Earnings Per Share of the company. If there
is a buyback, then the total number of shares outstanding reduces, thereby
increasing the EPS of the company (without any changes in the fundamentals
of the company). This increased EPS lowers the PE ratio of the company.

Though most companies buyback shares as per the Share Buyback Agreement,
however, one should be mindful that the management can adopt such
measures to increase EPS without any positive change in the company’s
fundamentals.

Significance of Enterprise Multiple

 Investors primarily use an organization’s EV/EBITDA ratio in order to
determine whether a company is undervalued or overvalued. A low
EV/EBITDA ratio value indicates that the particular organization may well
be undervalued, and a high EV/EBITDA ratio value indicates that the
organization may well be overvalued.
 An EV/EBITDA ratio is beneficial for transnational comparisons as it
ignores the distorting effects of individual countries’ taxation policies.
 It is also employed to find out attractive takeover candidates since
enterprise value also includes debt and is thus a much better metric than
the market cap for mergers and acquisitions (M&A). An organization with a low
EV/EBITDA ratio will be viewed as a decent takeover candidate.
source: Bloomberg.com

 EV/EBITDA ratios vary based on the type of business. So this multiple

should be compared only among similar businesses or should be
compared to the average business generally. Expect higher EV/EBITDA
ratios in high-growth industries, like biotech, and lower multiples in
industries with slow growth, like railways.
 The EV/EBITDA ratio inherently includes assets, debt, as well as equity in
its analysis as it includes the enterprise value and Earnings before Interest
Taxes Depreciation and Amortization values.
  An organization’s EV/EBITDA ratio provides a perfect depiction of total
business performance. Equity analysts use the EV/EBITDA ratio very often
when making investment choices.

For example, Denbury Resources INC., an oil and gas company primarily based in
the US, reported its first-quarter financial performance on the 24th of June,
2016. Analysts derived and calculated the organization’s EV/EBITDA ratio.
Denbury Resources had an adjusted EV/EBITA ratio of 5x. It had a forward
EV/EBITDA ratio of 13x. Each of those EV/EBITDA ratios as compared to
alternative organizations having a similar business and also to past organization
multiples. The organization’s forward EV/EBITDA ratio of 13x was more than
double the enterprise value at the same point in time in 2015. Analysts found
that the increase was because of an expected decline in the organization’s
EBITDA by 62%.

Limitations of EV/EBITDA
EV/EBITDA ratio is an effective ratio that stands above other traditional
techniques similar to it. However, it does have certain drawbacks, which have to
be known before using this metric to make sure you are less affected by them.
The main drawback is the presence of EBITDA in the ratio. Here are some of the
EBITDA’s drawbacks:

 EBITDA is actually a non-GAAP measure that allows a larger amount of

discretion on what is and what is not added within the calculation. This
also implies that organizations usually modify the things included in their
EBITDA calculations from one reporting period to the other.
 EBITDA initially came into common use with leveraged buyouts in the
Eighties. At that time, it had been employed to indicate the ability of an
organization to service debt. As time passed, it became widespread in
 industries with expensive assets that had to be written down over long
periods of time. EBITDA is currently commonly quoted by several firms,
particularly within the tech. sector — even when it is not secured.
 A common misconception is that EBITDA represents cash earnings.
Although EBITDA is a smart metric to judge profitability, it is not a
measure of cash income. EBITDA also leaves out the money needed to
fund the working capital and also the replacement of previous equipment,
which might be vital. Consequently, EBITDA is commonly used as an
accounting gimmick to dress up a company’s earnings. When using this
metric, it is vital that investors additionally look at alternative performance
measures to make certain that the organization isn’t making an attempt
to hide something with the EBITDA value.

Which sectors are best suited for valuation using EV

to EBITDA
Generally, you can use EV to EBITDA valuation method to value capital intensive
sectors like the following –

 Oil & Gas Sector

 Automobile Sector
 Cement Sector
 Steel Sector
 Energy Companies

However, EV/EBITDA cannot be used when the current cash flow is negative
Alternative to EBITDA
There is something called as the adjusted adjusted-EBITDA in accounting
parlance, which can be a better alternative of EBITDA because of having fewer
drawbacks. Adjusted EBITDA is a metric calculated for an organization by adjusting its
“top line” earnings, for extraordinary items, before deducting interest expense,
taxes and depreciation charges. It is often employed to compare similar firms
and for the purpose of valuation.

Adjusted EBITDA differs from EBITDA in that, adjusted EBITDA normalizes

financial gains and expenses since different organizations might treat each kind
of financial gains and expenses in a different way. By standardizing cash flows
and discounting anomalies, which might occur, adjusted, or normalized, EBITDA
can give a better measure of comparison while evaluating multiple
organizations. The adjusted-EBITDA can be expressed in a formula as follows:

The adjusted-EBITDA can be expressed in a formula as follows:

Adjusted EBITDA = Net Income – Other Income + Interest + Taxes +

Depreciation & Amortization + Other Non recurring charges

So when it comes to the calculation of the EV/EBITDA ratio for a business

organization, the use of EBITDA value can be replaced by the use of adjusted-
EBITDA value. The change is more preferable as the adjusted-EBITDA value has
more accuracy than the simple EBITDA value.

Below is a snapshot of Square Adjusted EBITDA reported in its S1 registration

document.
source: Square SEC Filings

Conclusion
EV/EBITDA ratio is an important and widely used metric to analyze a company’s
Total Value. This metric has been successful in solving the problems
encountered while using the traditional metrics, like the PE ratio, and hence it is
preferred over them.

Also, as this ratio is capital-structure-neutral, it can be effectively used to

compare organizations with different ranges of leverage, which was not possible
in the case of the simpler ratios.