What does EV/EBITDA measure and why is it used?

• A. A ratio of market capitalization to EBITDA used to value growth stocks.
• B. A profitability ratio focusing on after-tax profits.
• C. A liquidity ratio measuring ability to meet short-term obligations.
• D. Enterprise value divided by EBITDA, used to compare operating performance across firms, less affected by capital structure and taxes.

Answer: (D)

Focus on what the multiple compares: enterprise value relative to EBITDA. Enterprise value represents the total value of the company to all providers of capital (debt, equity, minority interests, and cash adjustments), while EBITDA is earnings before interest, taxes, depreciation, and amortization—the operating profitability of the business before financing decisions and non-cash charges. By dividing enterprise value by EBITDA, you’re getting a gauge of how much investors are willing to pay for each dollar of operating earnings, independent of how the company is financed or taxed.

This is why it’s useful for comparing firms: different companies can have different debt levels and tax rates, but the core operating performance (how well the business generates earnings from its operations) can be analyzed on a common footing. EV/EBITDA helps identify whether a company is cheap or expensive relative to peers in terms of its core profitability. It’s widely used in valuation and deal-making for that reason.

Keep in mind it has limits: it omits working capital needs and capital expenditures, and EBITDA can be inflated by accounting adjustments or exceptional items. It also ignores non-operating income and the cash costs of debt service and taxes, which can be important for some assessments.