EV / EBITDA stands for Enterprise value (EV) divided by Earnings before interest, taxes and depreciation (EBITDA).
EV is a measure of the company’s total value and can be considered as the sum of money that needs to paid to all the stakeholders by the acquirer if he/she intends to buy the company today.
EBITDA is a measure of the company’s operating performance. It indicates the amount of profit the company earned via its core business operations before paying interest expense, taxes etc.
Suppose EV of a company is Rs.10,000 and EBITDA for the previous financial year was Rs.2,500. EV/EBITDA of the company is 10,000 / 2,500 = 4.0x.
EV/EBITDA is a valuation ratio and helps understand whether the company is overvalued or undervalued. The best way to use a EV/EBITDA ratio is by comparing the ratio of different companies operating in the same sector. A company with lower EV/EBITDA is considered to be undervalued in comparison with company with higher EV/EBITDA. However it is important to understand the reason behind the undervaluation.
Suppose company A has EV/EBITDA of 4.0x whereas company B has EV/EBITDA of 6.3x. If the market is expecting B to grow at a faster rate, higher valuation for the same is justified. However suppose market has not understood company A’s potential correctly, then the lower valuation multiple is justified and presents a buying opportunity of the stock. If market has ignored A because of poor earnings or bad management practice, it is better to ignore the same in spite of relative cheapness.