INVESTOR LETTER #108
EV/EBITDA
EV/EBITDA is one of the most widely used valuation metrics in the investing world. Unlike the P/E ratio, which looks only at the value of a company's equity, EV/EBITDA values the entire business—including its debt and cash. It helps investors compare companies with different capital structures and is especially useful for capital-intensive businesses, acquisitions, and comparing companies within the same industry.
INVESTOR NOTE
A business owner thinks in decades. A speculator thinks in minutes.
Buying a Business, Not Just Its Shares
Imagine you want to buy a restaurant. The owner says the price is ₹5 crore. Just as you're about to sign the agreement, you discover the restaurant has ₹2 crore of debt that you'll also have to repay. Suddenly, your actual cost isn't ₹5 crore—it's ₹7 crore. Now imagine another restaurant selling for ₹5 crore but with ₹1 crore sitting in its bank account. In reality, that business is cheaper because you'll receive that cash after buying it. This is exactly why professional investors look beyond the stock price.
Why P/E Sometimes Misleads
Two companies can have exactly the same P/E ratio while having completely different amounts of debt. One company may have borrowed heavily to grow, while the other has almost no debt. Although their earnings appear similar, the risk faced by investors is very different. The P/E ratio doesn't capture this difference.
What Does Enterprise Value Mean?
Enterprise Value, or EV, represents the total cost of buying an entire business. It includes not only the value of the company's shares but also its debt, while adjusting for the cash already sitting on the balance sheet. It answers the question: 'How much would it really cost to own this entire company?'
Why EBITDA Is Used
EBITDA measures a company's operating earnings before the effects of financing decisions, taxes, and certain accounting expenses. It gives investors a cleaner view of how the core business is performing without being influenced by how the company is financed.
Putting the Two Together
The EV/EBITDA ratio compares the total value of a business with the earnings generated by its operations. It helps investors understand how expensive the entire business is relative to the cash-generating ability of its core operations.
Comparing Apples With Apples
Suppose two companies manufacture cement. One borrowed heavily to build new factories, while the other funded its expansion mostly through retained profits. Even if their P/E ratios look very different, EV/EBITDA allows investors to compare the businesses on a more consistent basis because it considers the effect of debt.
Especially Useful in Some Industries
EV/EBITDA is commonly used for manufacturing companies, telecom businesses, airlines, infrastructure companies, industrial firms, and other businesses that require significant investments in factories or equipment. It is also frequently used during mergers and acquisitions because buyers purchase the entire business, not just its shares.
It's Not Perfect Either
Although EBITDA is useful, it ignores capital expenditure. Some businesses need to spend huge amounts every year just to maintain their operations. Looking only at EBITDA may make such businesses appear healthier than they actually are. That's why experienced investors also study free cash flow.
Lower Doesn't Always Mean Cheaper
A low EV/EBITDA ratio may indicate an undervalued opportunity—but it can also reflect declining profits, weak growth prospects, or serious business problems. Just like every other valuation metric, it should always be interpreted alongside business quality.
Always Compare Similar Businesses
EV/EBITDA works best when comparing companies operating in the same industry. Comparing a software company with a steel manufacturer usually doesn't produce meaningful conclusions because their economics and capital requirements are completely different.
Think Like an Acquirer
Whenever professional investors evaluate a company, they often imagine buying the entire business rather than purchasing a few shares. EV/EBITDA encourages exactly this mindset by focusing on the total value of the enterprise instead of only the stock market value.
One Question Before Using EV/EBITDA
Whenever you compare two companies, ask yourself: 'If I had to buy both businesses today—including their debt and cash—which one would actually be the better deal?' That's the question EV/EBITDA is designed to answer.
INVESTOR PRINCIPLE