The key challenge is to identify the relevant information and further interpret it to the best of one's advantage. Sometimes the reports are so long and complicated that an average investor satisfies himself by knowing the differential between 'CMP' and the 'target price' along with the time period. This happens primarily because there are newer tools and techniques used in analysis. 'EV/EBITDA' is one such new thing. Though this may not be a new concept for institutional investors the individual investors are not accustomed to this new animal. Especially when most of the research reports talk about this ratio, it becomes all the more important to know about it.
EBITDA or earnings before interest tax depreciation and amortisation connotes operating profits. EV on the other hand denotes enterprise value. The successful investors reiterate that equity investing is not about buying and selling stocks but buying and selling businesses. The concept of EV necessarily underlines this thinking. It makes an investor to look beyond just a share but a firm as a whole. It does make an investor think as if he is buying or selling the business.An investor who wants to buy out the company has to pay the market capitalisation. Market capitalisation is arrived at by multiplying the number of equity shares issued with the current market price of the share. EV indicates the cost of acquiring a business and is arrived at, by adding the debt payable to the market capitalisation and deducting the cash from the market capitalisation.
EV thus gives the true picture of the cost associated with acquiring a business. The market capitalisation of a firm is the upfront cost payable to acquire a firm. However, one should note that the debt on the books of the company may act as a drag on the future cash flows of a company. The investor is forced to pay the interest over the term of the debt, and at the end of the term the principal is repayable. Same is the case with the cash and other near cash assets of the company. Everyone likes cash and so do the analysts. While buying out a firm the cash and near cash assets offer a cushion to the buyer. Near cash assets include liquid investments. In time of need the company can use the cash to meet the requirements and further funds can be raised by selling out the near cash assets.
The concept of EV works best when seen along with the operating profit. The EV/EBITDA multiple is a good indicator of value. Lower this ratio better it is for the investor. When one compares Ashok Leyland with Force Motors purely in terms of P/E, Ashok Leyland looks cheaper. However, when they are compared in terms of EV/EBITDA they appear to be valued at par with each other.
Similar observation is being made on the P/E front when one says that TVS Motors is costlier than Hero Honda. However, on the EV/EBITDA parameter TVS Motors looks cheaper. Things become further complicated when one looks at Bajaj Auto and Mahindra & Mahindra. These two stocks look overvalued when compared to other companies in similar segments. However, when one adjusts their EV to the extent of their quoted investments, the valuation gap between these companies and their peers narrows. Experts reckon that the unquoted investments of these two companies can further pull down the EV/EBITDA ratio.
This number game can be played tirelessly. This calls for only one thing qualitative judgment. Instead of getting buoyed by the standalone valuation tools, one has to look at various enterprise value drivers. At the end of the day it is the value that determines the future course of an investment.