How Investment Bankers Determine Profitability - dummies

How Investment Bankers Determine Profitability

By Matt Krantz, Robert R. Johnson

Even if you’re not an investment banker, you probably have heard of P/E ratios and price-to-book. Investment bankers are drawn to strange-sounding words and acronyms, especially to get a better handle on valuation.

Enterprise value to EBITDA is certainly a ratio that’s a bit off the beaten path. But it’s designed to give investment bankers a more accurate read on how richly the market values a company by making a number of arcane, but reasonable adjustments.

These adjustments can give investment bankers a way to compare how richly different companies are valued, even if these companies are carrying different amounts of debt. The enterprise value/EBITDA ratio is often used along with the P/E by investment bankers to see how pricey a company is.

Market value is certainly the most common way for investors to gauge how much a company is worth. Market value is the company’s stock price multiplied by its number of shares outstanding.

But market value, while objective, has its shortcomings when it comes to measuring the value of a company. A company’s market value is a reflection of the value of the company’s stock. Stock investors, in theory, give a company’s value a haircut to reflect the debt the company is carrying.

This valuation haircut makes total sense for stock investors, but not so much for investment bankers who need to know how much the entire company, not just its stock, is worth.

To make the market value statistic fit their needs, investment bankers often use enterprise value, which is the market value of a company with its net debt added back.

Enterprise Value = Market Value − Cash and Short-Term Investments + Total Debt

You’re now halfway to understanding the enterprise-value to EBITDA ratio.

Another acronym you’re guaranteed to hear if you hang out with investment bankers is EBITDA. EBITDA is short for earnings before interest, taxes, depreciation, and amortization. The EBITDA measure is investment bankers’ answer to the widely accepted but flawed measure of corporate earnings called net income. EBITDA involves a series of adjustments to net income to get to a measure of profitability that’s not distorted by accounting or financial maneuvers.

EBITDA is calculated as follows:

EBITDA = Net Income + Tax + Interest + Depreciation and Amortization

Now that you’re a master of enterprise value and EBITDA, the trick is to bring them together. Dividing enterprise value by EBITDA tells investment bankers the total value placed on a dollar of the company’s earnings adjusted items that don’t cost cash, like depreciation and amortization.

Since we’re already talking about EBITDA, it seems only natural to discuss EBIT. EBIT is — you guessed it — earnings before interest and taxes. EBIT is a way to look at a company’s profit that makes it a bit easier to compare with different companies. The measure adjusts a company’s profit, adding back interest expenses and taxes, to get at a company’s core, or operating profit. EBIT is calculated as follows:

EBIT = Revenue − Cost of Goods Sold − Operating Expenses − Depreciation − Amortization

Some investment bankers loosely interchange EBITDA with cash flow from operations, but that’s not completely accurate. EBITDA and cash flow from operations involve different calculations.