What Is EBIT/EV Multiple?
The EBIT/EV multiple is a financial ratio used to measure a company's "earnings yield." EBIT stands for earnings before interest and taxes, while EV is enterprise value. The concept of this multiple as a proxy for earnings yield was introduced by Joel Greenblatt, a noteworthy value investor and professor at Columbia Business School.
Understanding EBIT/EV Multiple
Enterprise value (EV) is a measure used to value a company. Investors often use EV when comparing companies against one another for possible investment because EV provides a clearer picture of the real value of a company as opposed to simply considering market capitalization.
EV is an important component of several ratios investors can use to compare companies, such as the EBIT/EV multiple and EV/Sales.
The EV of a business can be calculated using this formula:
EV = MC + Total Debt − C
MC = Market capitalization, which is equal to the current stock price multiplied by the number of outstanding stock shares.
Total Debt = The sum of short-term and long-term debt.
C = All cash and cash equivalents.
The EV result shows how much money would be needed to buy the whole company. Some EV calculations include the addition of minority interest and preferred stock. However, for the vast majority of companies, minority interest and preferred stock in the capital structure is uncommon. Thus, EV is generally calculated without them.
If EBIT/EV is supposed to be an earnings yield, the higher the multiple, the better for an investor. Thus, there is an implicit bias towards companies with lower levels of debt and higher amounts of cash. A company with a leveraged balance sheet, all else being equal, is riskier than a company with less leverage. The company with modest amounts of debt and/or greater cash holdings will have a smaller EV, which would produce a higher earnings yield.
- Investors and analysts use the EBIT/EV multiple as a financial ratio to measure a company's earnings yield and to determine the company's value.
- The higher the EBIT/EV multiple, the better for the investor as this indicates the company has low debt levels and higher amounts of cash.
- One of the benefits of the EBIT/EV multiple is it allows the investor to effectively compare earnings yields between companies with different debt levels and tax rates.
Benefits of EBIT/EV Multiple
The EBIT/EV ratio can provide a better comparison than more conventional profitability ratios like return on equity (ROE) or return on invested capital (ROIC). While the EBIT/EV ratio is not commonly used, it does have a couple of key advantages in comparing companies.
First, using EBIT as a measure of profitability, as opposed to net income (NI), eliminates the potentially distorting effects of differences in tax rates.
Second, using EBIT/EV normalizes for effects of different capital structures. Greenblatt states that EBIT "allows us to put companies with different levels of debt and different tax rates on an equal footing when comparing earnings yields."
EV, to Greenblatt, is more appropriate as the denominator because it takes into account the value of debt as well as the market capitalization. A downside to the EBIT/EV ratio is that it does not normalize for depreciation and amortization costs. Thus, there are still potential distorting effects when companies use different methods of accounting for fixed assets.
Example of EBIT/EV Multiple
Say Company X has EBIT of $3.5 billion, market capitalization of $40 billion, $7 billion in debt, and $1.5 billion in cash. Company Z has EBIT of $1.3 billion, market cap of $18 billion, $12 billion in debt, and $0.6 billion in cash.
EBIT/EV for Company X would be approximately 7.7% while the earnings yield for Company Z would be approximately 4.4%. Company X's earnings yield is superior not only because it has greater EBIT, but also because it has lower leverage.