Enterprise value to earnings before interest and taxes (EV/EBIT) is a financial metric used to ascertain how a stock or asset is valued relative to the overall industry. In most cases, analysts use the metric to determine if an underlying stock is priced too high or too low relative to other stocks in the same sector.
While similar to Price to Earnings ratio, EV/EBIT is considered a more accurate measure, as it covers up a number of shortcomings. EV/EBIT, while also similar to EV/EBITDA, does not take into consideration depreciation and amortization when it comes to computation.
The financial metric measures a company’s enterprise value relative to earnings generated before interest and taxes. Enterprise value, on the other hand, is a measure of an asset or a company’s total value. Rather than focusing on the equity value alone, enterprise value takes into consideration the entire market value and is most of the time deemed as the effective cost to buy an asset or a company.
Enterprise value is calculated by adding market capitalization to the market value of debt, then subtracting cash and equivalents.
However, the extended formula is:
Enterprise Value = Common Shares + Preferred Shares + Market Value of Debt + Minority Interest – Cash and Equivalent
Once the Enterprise value is calculated, it is divided by the Earnings before Interest and Taxes to provide a ratio that ascertains the intrinsic value of a company or asset. For this reason, the EV/EBIT ratio is often used as a valuation metric to compare the value of an asset or company relative to other similar assets or companies in the same segment.
This financial metric is of great importance when ascertaining how a company or asset is valued relative to the overall market. A higher ratio relative to the industry average is most of the time associated with overvalued conditions.
While a higher valuation would be beneficial to a person selling shares of a company or an asset, they can spell disaster to the person acquiring the same assets or shares. The market can catch up with such high valuation, resulting in a realignment that triggers proper valuation. It is thus common to find share prices of a company with high EV/EBIT plummeting after some time as investors take note of the high valuation.
Likewise, Low EV/EBIT ratio can be interpreted as undervaluation relative to the overall industry. What this means is that shares of the company are trading at a discount and are not an accurate representation of the overall company’s worth. Once the market attaches the accurate value to the business, it is common to see shares of the affected company’s skyrocketing in value.
Unlike a high EV/EBIT ratio, a low ratio is often associated with a financially stable and secure company. This is usually the best time for value investors to buy into a company to take advantage of potential price upswing when the market attaches the proper valuation to the business.
EV/EBIT is an important financial metric for value investors who wish to assess the true value of a company or an asset. The metric can be of great help in pegging the target price of a company’s worth relative to industry peers.