Hi. How come so many valuations we see on Wall street use Enterprise Value divided by EBITDA. Why use EBITDA as a proxy for Cash Flow from Operations… rather than use CFO itself? What am I missing?
Enterprise Value is the perceived true value of the Firm if someone was to buy the firm. Mkt value of Common and Pref. Stock + Mkt Value of Debt - Cash and Investments. EV/EBITDA would give you an EBITDA multiple of what an acquirer would would have to pay for the acquisition. (perceived) Also, when looking at Price multiples the denominator may be negative so this will solve that problem. IE. P/CFO The material is covered in Level II within the Equity section Reading #43.
Well EV/EBITDA is far from useless as a multiple. The idea as I understand it is to give the value of the firm including debt relative to earning before financing decisions come into play. It can be useful for assessing nascent industries where EPS is negative. Like any multiple, it should only ever be one of several valuation metrics you consider. EV/EBITDA has many limitations, the most obvious being that two companies can have similar EBITDA but massively different Net Profit which is ultimately what counts for equity holders. I agree with you that it is overused by analysts. In my experience it is often used as a way to attempt to demonstrate that heavily indebted companies are not overvalued. One should always be very wary of companies that quote themselves as being EBITDA profitable or have EBITDA interest cover of X. In fact the more a company talks about EBITDA, the more of a red flag it is. EBITDA is not a good measure of cash flow as you say. I would not look to CFO if doing a cash flow multiple though. I think FCFF is more relevant. In my opinion EV/FCFF > P/FCFF > EV/CFO.
In addition, you see a lot of M&A and LBO analyses using EV/EBITDA as the primary valuation metric. It’s a good measure for takeout valuation which I described here in October 2008 (http://www.wallstreetoasis.com/forums/lbo-valuation-question): “- DCF model - discounted cash flow analysis measures the intrinsic value of a company based on the present value of its projected cash flows - LBO model - helps you assess the returns that a PE firm can get by buying a company in a leveraged transaction. Essentially the purpose of a leveraged transaction is to acquire a company with a large amout of debt but an amount that can still be serviced or paid down via cash flow generation. Over time, debt obligations are paid off which expands equity value (remember that EV = equity + debt - cash), so ultimately the goal is to expand enterprise value and thereby equity value off of a small initial equity commitment. I assume you know this if you made it to the final rounds of a leveraged finance interview. Anyway, LBO models enable PE investors to assess the internal rate of return (IRR) of a prospective investment and how that may vary based on different sensitivities and capital structures, which are things that basic DCF’s do not enable you to do. - Entry/exit multiples - your entry multiple is just the EV/EBITDA multiple that you pay for a particular investment. Usually you come up with this number based on comps and precedent transactions. Your exit multiple is just the multiple you think you can sell the company at when you exit. Normally you assume no multiple expansion unless you have some compelling reason otherwise because of industry trends, favorable organic growth or expansion through acquisitions, or just a better market environment overall. Given the current state of the economy, I don’t think there is a good reason to bake multiple expansion into your model. - Other things you should know about the current deal environment, just so you aren’t completely out of touch with what’s happening on Wall Street: you’re looking at senior debt with interest upwards of 8-9% (think LIBOR + 450-550 bps) and mezz debt upwards of 15% right now, with many lenders expecting the credit environment to further deterioriate through early 2009. Credit is very hard to come by right now, but there is still some available financing in the middle markets. What’ll eventually happen is that as interest rates come down to stimulate the general economy, more lenders will enter the market because they know that they can extend credit at lower rates and still make a killing…so like everything else, things come in cycles and credit will eventually be available again. But right now things are not looking good; credit is very expensive and a lot of PE shops are really focusing on portfolio management rather than new deals from now through year end. Capital structure of a lot of transactions, at least in the middle market (where I work), is usually something like 40% senior debt/20% mezz/40% equity these days. No more 80% debt/20% equity transactions – not now, and not for a while. Hope this helps…some of it was hastily written because I want to go to bed, but hopefully it’s still all coherent. Good luck with your interview.” It’s also worth mentioning that EV/EBITDA is the metric that you use to calculate your IRR, which is what buy-siders care about (as well as cash-on-cash returns). Hope this helps
Here are some articles about using EBTIDA…all pointing out the negatives, but valid points nonetheless http://www.businessweek.com/bwdaily/dnflash/jan2003/nf20030114_1115.htm http://findarticles.com/p/articles/mi_m0ITW/is_3_84/ai_n14897014/ http://www.allbusiness.com/accounting-reporting/reports-statements-cash/807702-1.html