EV/EBIT — Cleaner than P/E

EV/EBIT, or Enterprise Value/Earnings Before Interest and Taxes, offers a more complete picture of a company's valuation by taking into account both its equity and liabilities. Unlike the P/E ratio, which only uses the stock's market value in the numerator, EV/EBIT includes the company's entire value (EV), which consists of the market value plus net debt. This makes the measure particularly valuable for comparing companies with different debt levels or in industries where liabilities are a natural part of the business.

By excluding interest costs and tax effects from the denominator (EBIT), the measure focuses on the company's underlying operating profitability, giving a cleaner picture of its core business.

The great strength of EV/EBIT lies in its ability to neutralize the effects of financing structure and tax system. Two companies can have identical P/E ratios but entirely different valuations if one has significantly high liabilities. EV/EBIT addresses this by including liabilities in the valuation and showing what a buyer would need to pay to acquire the entire company, not just the stocks.

This makes it a superior measure for assessing value for acquisitions and for comparing companies within the same industry, where operational performance rather than financial decisions should be the primary basis of assessment.

The first practical step is to calculate the Enterprise Value (EV). This is done by taking the company's market value (share price multiplied by the number of outstanding stocks) and adding its total interest-bearing debt — the liabilities that carry interest. Then any liquid funds and short-term investments are deducted, since these can be used to pay off parts of an acquisition. The next step is to find the most recent year's EBIT, which is found in the income statement and represents the company's operating profitability before interest costs and taxes.

By dividing EV by EBIT, the EV/EBIT ratio is obtained. For this measure to be meaningful, it must be compared with the average for the industry as well as with the company's own historical valuations. A lower value indicates that the stock is relatively cheaper in relation to its operating profitability.

When using EV/EBIT to find undervalued companies, it is crucial to ensure that the companies compared are genuinely comparable. This includes not only the same industry, but also similar business models, risk profiles and growth prospects. A low EV/EBIT can be a sign of a good deal, but it can also be a warning signal that the market expects a future decline in profitability or growth.

Therefore, the analysis is always complemented with a fundamental review of the company's competitiveness, management and future prospects. The goal is not to find the lowest EV/EBIT ratio, but the one that represents a reasonable premium for the future risk and growth.