Have you recently come across more and more equity research reports mentioning how a company is “cheaper” than its counterparts? And then searched for the familiar PE/PB Ratio charts but instead, got bombed with esoteric words like EV and EBIDTA multiples spattered all over the page? And then wondered where the good old comparison went?

Well, PE is no more a primary valuation tool any more. And while there are many more thumbrules in place than earlier, the Acquirers Multiple is getting more and more popularity! And if you want to be in the know, nows the time to understand what it means!

Think Like a Corporate Raider

Put yourself in the shoes of a Machiavellian corporate raider! What would you pay to acquire a company in the market – the answer would be simple. Something called the Economic Value which is nothing but the amount you need to pay for acquiring all the listed equity, the market value of the debt less the cash you would get.

So when you get around to comparing another company with the first one, what would you want to see? Which of the two companies can generate more bang for the buck right? So it means you would not look at Profits – as they get impacted by a lot of balance sheet and depreciation items – but at core business profitability, also measured by something called EBIDTA (Earnings before Interest Depreciation Tax and Amortisation).

In other words, you – the Wall Street Mean Toughie – are looking for which company can generate more operating profit per unit of your money! Or in other words, the lower EV/EBIDTA company is more atrractive! Right?

To simplify the math, here it goes:

Enterprise value (EV) is calculated in the following way: EV = Market Cap of shares + Total Debt  – Cash

This multiple has increasingly gained ground with analysts as a key Enterprise Value Multiple (compared to equity multiples like P/E, PEG,P/BV etc) and you are likely to encounter more and more of this term.

So why all this trouble?

Most investors tend to use P/E as a benchmark for valuations but it suffers from limitations. When you are buying into a share, you are also indirectly buying into the debt and capex of the company without realising it – but the PE ratio only considers the equity aspect and not the debt capital. It just considers net profit as the residual income generated for equity shareholders without looking at operating profitability.

In addition, P/E is tricky for loss-making companies , startups and cyclical companies which may have negative or negligible earnings and is therefore ideally suited for mature industries and companies within them. The acquirers multiple however can be computed even for firms that are reporting net losses, since earnings before interest, taxes and depreciation are usually positive.

Of course, PE is a simpler measure especially as the calculations of the EV/EBITDA multiple can be difficult as well as the market value of debt may not be always known.

So is EV/EBITDA a perfect ratio? Of course not. First it looks threatening in its conception! Second, it doesn’t consider the nature of cash flows post operating profitability and how these are being spent – capex, interest etc.  And many more. However, the fact is, when you look at what a company”s market value should be if you are a raider, you do get the first intuitive grasp of the concept. And hence its popularity.

.You could visit popular free screeners like to play around with the multiple or for an illustration of sectoral multiples in the US, please do visit the website of one of the biggest gurus of valuation theory:

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