Invest Using EV/EBITDA Multiple

Stock market experts have different ways to look at many financial ratios to make important investment calls. One such superior and effective measure of valuation is Enterprise value-to-EBITDA (EV/EBITDA). This ratio makes peer comparison easy by normalizing the difference in company’s capital structure.

Enterprise value is a broader word and includes value of equity, value of debt, value of preferred stock and minority interest. It is generally calculated by estimating the present value of forecasted future cash flows and terminal value of business. Enterprise value can also be called as economic value of business. Equity valuation of a company is derived from Enterprise value by making certain adjustments. This Equity value when divided by number of shares issued by the company helps to calculate the intrinsic value of a share. Hence the main differentiating factor between Enterprise value and equity value is that Enterprise value includes value of all stakeholders of the company i.e. people who have provided funds as loans/debt/preferred shares /Equity shares etc.

The denominator for this ratio is EBITDA (Earnings before interest, depreciation and amortization). Since the numerator included value of equity and debt in the denominator we use EBITDA. This ratio has one more advantage of not getting influenced by different accounting policies relating to charging depreciation and amortization. Our research uses this ratio as a benchmark to study the returns of Indian stocks over the period.

We begin with all companies with market capitalization in excess of `1,000 crore, and select company with positive EV/ EBITDA ratio between 2012 and 2016. Share price return is then calculated with reference to prices as on 6 March 2017. Between the year 2012-17, average EV/ EBITDA for the selected stocks ranged from 12 to 16. So we created seven portfolios to capture if low EV/EBITDA shares generate better returns as compared to high EV/EBITDA stocks as well as BSE Sensex.

One year return was calculated as percentage change between price of one stock as on 6 March 17 over the price as on 6 march 2016. Best performing portfolio is highlighted with the green color and the worst portfolio is indicated with the red color.

In Table-1 we can clearly see that the best performing portfolios is the one with EV/EBITDA below 10. And the worst performing portfolio have EV/EBITDA higher than 25. Even when we look at Median values of CAGR returns we can draw a similar conclusion that low EV/ EBITDA portfolios perform much better than higher EV/EBITDA multiples. Retail investor when analyzing companies should prefer low EV/ EBITDA stocks for getting better returns. While selecting stocks beside low EV/ EBITDA investors should also consider future earning capacity of shares, quality of earnings and promoters stake.

Dr. Ruzbeh J Bodhanwala, Professor, FLAME University, ruzbeh.bodhanwala@flame.edu.in CA. Shernaz Bodhanwala, Asst. Professor, FLAME University, Shernaz.bodhanwala@flame.edu.in