Investors use this ratio to determine whether a company is undervalued or overvalued. A low ratio indicates that a company might be undervalued, and a high ratio indicates that the company might be overvalued. Enterprise Value, or EV for short, is a measure of a company’s total value, often used as a more comprehensive alternative to market cap. Market cap is the price of the stock multiplied by the number of outstanding shares. Simple enough, but it doesn’t really give us an entire picture of what a company is worth. For example, let’s say a company has 100,000 outstanding shares and the price per share is $25. The market cap is $2,500,000. Enterprise Value takes the market cap, but it also adds debt and subtracts any cash the company has. So, if this company had $500,000 in debt and $250,000 in cash, the Enterprise value would be $2,750,000. EV gives us the real value of a company. If we were going to buy this company, it would cost us $2,750,000, not $2,500,000 which is the market cap figure. This is a great tool to use and I like to use the Enterprise Value with EBITDA to come up with a ratio that can compare two like companies. EBITDA is Earnings before interest, taxes, depreciation, and amortization. I use this along with the PE Ratio. PE is great, but it just takes a look at the equity base, whereas the EV/EBITDA factors in debt as well. So, using the EV/EBITDA ratio is good when looking at companies that have more debt and/or leverage. We don’t want to buy companies with a lot of debt. Our rule of thumb is that a company we buy can pay off their debt with 5 years’ worth of cash assets or sooner, otherwise, it’s too much debt for our taste. But if they do have debt that can be paid off, it’s still worth taking a look at. In that case, we can use the EV/EBITDA ratio to compare companies within the same industry. Don’t worry about doing the entire math or searching the company financial statements to get this information. Yahoo Finance has this for you under their “Statistics” tab. When using the EV/EBITDA ratio, the lower the figure the better, just like P/E, P/S, P/BV, etc.
The chart above shows the EV/EBITDA for Bed Bath and Beyond. The ratio is 4.68. That’s pretty low, but how does that compare to their competitors? Here is a chart for Williams-Sonoma:
WSM has an EV/EBITDA of 6.45. That is also very good, but comparing the two, BBBY looks like a better value ALL ELSE BEING EQUAL.
Lastly, here is a chart for Amazon. I love this company and I wish I owned some shares earlier this year. I love the company, but if we are comparing AMZN to BBBY and WSM, this one looks pretty overvalued with an EV/EBITDA of 32.56.