By William — September 19, 2014

You will recall from the free Investing Basics series how just about any investment is valued as a multiple of earnings. This is particularly true when youre thinking of buying or selling a private business, or stock in a publicly traded corporation. In the latter case, the multiple is called the P/E ratio, or PE for short.

Thats a good starting point, but if you want to become a better investor, there are (as in anything in life) a few subtleties you need to know to become better at it. The good news is theyre not many, and theyre not difficult.

Today I want to introduce two concepts that usually get used together: enterprise value (EV) and EBITDA. Theyre just variations of the old-fashioned balance sheet and income statement we use to assess the value and performance of any company. Some call them refinements, but I just see them as two different points of view.

So, whats wrong with the old-fashioned balance sheet? I mean, balance sheets have been around ever since the tooth fairy used it to value her business. So, why do we need something else?

Because man is evil, and managements worse. Managements have figured out how to bamboozle good, honest investors so they can collect bigger and bigger bonuses. How?

They heard you use the PE to value any business, so they become shifty. Lets see how.

Imagine you fire up your trusty stock screener, looking for a solid and safe stock to invest in, one which will help you get comfortable in a few years. Suddenly, you see something curious, two almost identical companies, Irresposible Inc. (IRR) and Conservative Corp. (RESP). Both have the same PE, same stock price, same everything almost.

Two identical companies (click to enlarge)

Lets imagine someones trying to talk you into buying some IRR from him. Look, they have the same stock price, same PE, same EPS.

If you wanted to buy either company outright, youll multiply the stock price with the total number of shares, right? Thats also called the market cap, as in total market capitalization. Because both have 1,000 shares trading for $30 per share, the total market cap for both would be $30,000.

If you look any company up using your trusty Yahoo Finance or Google Finance website, youll see somewhere on the site theyll all tell you the companys market cap. Some, like Apple, have enormous market caps, others are small. Some, therefore, are called large cap stocks, midcap stocks or small cap stocks some even are called microcap stocks. (How easy is that? Who said investing was complicated? I told you this investing stuff is not rocket science.)

But youve been around investing long enough to know in your gut these two companies are not the same. How could they be? One is laden with debt and has no cash in the bank, while the other is flush with cash and has no debt. Yet they have same stock price and market cap. So how do you pin down the difference?

Good sense, you know, can usually be backed up with some hard evidence. But what evidence? Thats where the two new concepts, enterprise value (EV) and EBITDA (pronounced just like a dentist, a Bite the Bullet reading dentist, would say: open wide and say eebitdaaah.)

Lets go back to the market cap. If you look at the table above, you see both IRR and RESP have a market cap of $30,000. In theory, thats what youd pay if you took them over. (In practice, youd have to pay more to persuade stockholders to part with their stock, but thats another topic. Go with me for now.)

Here is where the two companies separate. When you buy Irresponsible (IRR) you will still be on the hook for their debt of $20,000. That debt doesnt go away. So you will end up paying that, too.

The businesss cash does not belong to the owner, it belongs to the business. And, after the deal is completed, youre the new owner, and you can draw out all that cash. In fact, you can draw out the cash and use it to pay the seller.

So, EV = Market Cap + Debt  Cash

Okay, so now you understand the concept of enterprise value, lets apply it to the two companies above, IRR and RESP.

Enterprise value of IRR and RESP

The last few lines show how you calculate the enterprise value for both companies. Now theyre not so identical any more, are they?

Be clear about this: Enterprise Value (EV) is not what the company is worth. Rather, it shows how much youre actually paying to get that income stream. Since both IRR and RESP have the same income stream, the EV shows you youre paying $49,000 for IRRs income stream, but only $15,000 for the identical income stream from RESP.

In other words, at $30 a share (the only number youre offered when buying stock) IRRs income stream is a lot more expensive than RESPs income stream. The PE ratio might have led you to believe theyre priced the same, but debt and cash can change that.

Now, lets look at the concept which usually is used along with EV: EBITDA

Most acronyms get referred to by either their proper name (earnings per share) or their acronym (EPS). Not EBITDA. Nobody ever refers to earnings before interest, taxes, depreciation and amortization. EBITDA has become a word, pronounced just like its written (eebitdaah).

Rather than explain it, lets just look at our example to show how (and why) its calculated. Below are our now familiar two companies, IRR and RESP, with their earnings adjusted back to EBITDA. You will notice I added the letters (I, T and DA) to help you follow along.

EBITDA for IRR & RESP

Heres the logic: we want to get to the essence of a company, and eliminate differences between companies that have nothing to do with their core businesses. Lets take them one by one:

Taxes: Some businesses had losses in the past, or have some other sweetheart tax deal (hello, tax inversion ) so they pay less taxes, while others dont. In order to compare apples with apples, we back out the taxes and get something called EBT (earnings before taxes): how much the company earned before taxes.

Interest: Some corporations fund their businesses with their own money, others use debt. Those with debt have to pay interest, which well capitalized companies dont. So, we take EBT and back out the interest to arrive at an earnings number that doesnt depend on a corporations capital structure. And we call that EBIT (earnings before interest and taxes).

The final thing we back out is Depreciation and Amortization, which are not cash expenses. Rather, its a tax and accounting theory-derived number. The logic behind it is simple enough: if you buy a delivery truck for $30,000 in 2010, you cant write off the entire amount in 2010 as an expense, because the truck gives you value for, say, five years. So you spread out the $30,000 over 5 years, and you get depreciation of $6,000 per year. Over the 5 year period, the entire cost of the truck is expensed easy enough. So the $6,000 per year expense is not a cash expense you spent the cash back 2010.

The problem with depreciation and its cousin, amortization (depreciation of intangible stuff like goodwill or patents) is no two companies do it the same way. There are many methods of depreciation and amortization (D&A): some companies are conservative and depreciate stuff as fast as they can to save on taxes. Others want to depreciate things as slowly as possible to make their earnings look good so the execs can get fatter bonuses. Both are legal, but they make companies hard to compare.

And so, to avoid the apples and oranges comparison, we simply back out D&A from EBIT, to get EBITDA.

Why the alphabet soup, other than to give us accounting geeks goosebumps for joy?

Heres why: so you, smart investor, can have a hard data tool to sift out the sneaky managements from the honest ones. Remember how we started with IRR and RESP having identical stock prices and PE ratios, but you just had that vague feeling of unease in your gut that these were not really identical?

Have that vague, uneasy feeling no longer. We now have a new multiple, one with X-ray eyes to see through the smoke and mirrors managements might use to bamboozle investors who dont read BBI. The new multiple is EV/EBITDA. EV is an X-ray version of the P in P/E, and EBITDA is the X-ray version of E.

And so, we morphed from P/E to EV/EBITDA as a tool to compare two companies.

Remember how we started out: the value of any business is expressed as a multiple of earnings? Now that we have stripped away a few variables that cloud the picture, here is what we are left with:

Look at that: no longer is Irresponsible Inc. valued the same as Conservative Corp. You can see RESP, at $30, is a lot more reasonably priced than IRR. Lazy investors, who listen to others and dont want to spend ten minutes (thats really all this exercise takes) doing some very elementary digging, those are the people who bid up the price of companies like IRR.

Warren Buffett and other smart investors dig just a little deeper, which is how they see potential winners other people miss.

The EV/EBITDA calculation does not replace the PE as a measure of how expensive or reasonably priced a company is. You check both. The PE comes to you straight off the first page of any site giving you pricing information, so thats no work at all.

When you have both, look at the difference: you can see with IRR theres no big difference the valuation drops from 15 to almost 12. However, RESP gives you a much bigger difference: 15 to less than 5. That gap is a good indication of the quality of a company and its management.

Finally, heres an exercise for you. Here is a presentation a company made to professional investors. Read it. Youve probably never heard of the company before. Its an interesting company, one with a PE over 70. That tells you serious investors really like this company.

Heres the exercise: see if you can figure out its enterprise value. The presentation clearly gives you the EBITDA, so I made that easy for you.

Once you get the enterprise value, do the math: EV ÷ EBITDA. Email me and tell me what you get, and if you think that tells you anything different from the PE.

Have fun!

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