Tuesday, May 27, 2008

*** New Video: V4. The EV/EBITDA Ratio

In order to address some of the shortcoming of the P/E Ratio - or at a minimum, try to provide additional information, another ratio that is very commonly used used is the EV/EBITDA ratio. Like the P/E ratio, this ratio uses one year of data and tries to establish a relationship between the value of the company and some measure of profitability. In order to adjust for the fact the earnings are influenced by interest cost, tax charges, depreciation and amortization - none of of which is directly linked to the operations of the company, this ratio compares this to the Enterprise Value of the company, which is the Market Capitalization (the market value of the equity (P x number of shares)) plus the net debt (debt - cash).

This measure therefore compares a broader measure of the company's value - one which includes net debt which an acquirer would have to assume, and compares it to EBITDA - a measure of the operating earnings of the company, thereby neutralizing the effect of varying interest levels between companies and depreciation policies. The EBITDA measure is not perfect, but clearly one can argue that it 'cleans' the earnings to provide a number that is more reflective of the operating performance of the company.

The drawback that it only looks at one year's worth of data remains.

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