We met EV and EBIDTA in the previous part of this series.
Walk with us through some examples... and we will discover what stories these two concepts together can tell us about companies and stocks.
Here are two cement companies - Madras Cements and India Cements. They are in the same business - that of making and selling cement. They operate in the same region and so are exposed to similar dynamics in demand and supply conditions.
| (Rs cr) | India Cements | Madras Cements |
| Equity | 140 | 12 |
| Debt | 1616 | 552 |
| Market Capitalisation | 614 | 587 |
| Cash and investments | 77 | 99 |
| Enterprise Value | 2153 | 1041 |
| EBIDTA | 275 | 150 |
| EV/EBIDTA (times) | 7.8 | 6.9 |
Here we know that the EV of Madras Cements is Rs1041cr while that of India Cements is Rs2173cr. Now what does that say about these companies?
On their own, nothing really helpful for stock-picking, right?
We need to compare their market values against their operating parameters. From the table, we also know their operating profit, i.e. EBIDTA.
The ratio EV/EBIDTA examines the market value of the company in relation to its earnings from operations. Here, an EV/EBIDTA of 7.8 for India Cements means that for every Re1 that India Cements earns from its operations - by making and selling cement - the market is giving a value of Rs7.8 to the company.
For Madras Cement, the market is paying just Rs6.9 for Re1 of earnings. If both these companies have similar quality of earnings, then you are getting Madras Cements cheaper than India Cements.
A caveat:It is important to understand the sustainability of the operating performance. Thus, it is always important to take the EV in relation to the expected EBIDTA.
Is there something special about EV/EBIDTA?
For one, EV takes into account the entire company - equity and debt - and how the market values it. This is where market capitalisation fails, especially when a company has humungous debt. If you are taking over a company, then you need to buy all its shares, sure, but you also need to pay off its debts. Market capitalisation concerns itself with just the market value of equity.
Second, EBIDTA is earnings purely from operations. And as we never tire of saying, it is the operational efficiency that is the primary source of value for the shareholders.
Net profit, on the other hand, is net of all expenses and incomes. And hence, it might be skewed by the interest outgo, which is solely dependent on the company's financial structure. Again, it might include huge chunks of 'other income' that might not be recurring. Or it might have anomalies regarding in change in policies - like accounting for depreciation and inventory.
And for this reason, EV/EBIDTA could help make better decisions than P/E...
Aside: Have you noticed that P/E is nothing but market cap/net profit?
In the same example, India Cements has a debt-equity of 2.03 while Madras Cements has a much lower debt-equity of 1.5. Had you checked just the P/Es of these two companies, you would have arrived at entirely different results.
| (times) | India Cements | Madras Cements |
| P/E | 14 | 15 |
| EV/EBIDTA | 7.8 | 6.9 |
On a PE basis, India Cements looks cheaper than Madras Cements. This camouflages the fact that Madras Cements has superior operations.
And what is interesting to note that even in the stock market Madras Cements has been a much stronger performer than India Cements. In fact, it has been the best performing cement stock even during the recent market sell-off.
A twist in the tale...
...rather a twist in the ratio
What if we reverse the ratio EV/EBIDTA and look at its from the opposite angle?
Meaning, what does EBIDTA/EV tell us?
It says that the market is getting Re1 from the operations of Madras Cements for every Rs6.9 that it is paying. The return on the market value of the total capital supporting the company is 14.5% (that is 1 divided by 6.9).
Similarly, the return that the market is getting from the operations of India Cements is 12.8% (1 divided by 7.8).
Returns... capital...hmm do they ring a bell? Haven't we discussed RoNW and RoCE? How is this ratio different from them?
Return on Net Worth (RoNW) tells us what the company has made on the shareholders' funds after all expenses have been paid. And since it deals with the net profit, it has a bearing on every aspect of the business - its profitability, efficiency and leverage.
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