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EBIT Multiple = Enterprise Value / EBIT

(EBIT stands for Earnings Before Interest and Tax. It is the profits of the company before the impact of interest income, interest expense and tax expense. As such it is an indicator of the earnings of a business excluding the impact of its cash holdings and borrowings).

Calculation of EBIT
Our calculation approach for EBIT is as follows:
EBIT = Profit Before Tax – Interest Income + Finance Cost – Abnormal / Extraordinary / Unusual Items.

Note: EBIT should equal the company’s stated Profit From Operations plus its share of income from Jointly Controlled Entities and Associates, less Interest Income (if it has included this in its Profit From Operations).

Why Look at EBIT?
By understanding the true EBIT of a business, we are in a better position to form a view of the underlying earnings of the business and hence its business value.

Enterprise Value
Enterprise Value is basically the value of a company excluding its cash and debt position. See explanation here.

Using EV/EBIT
EV/EBIT is also known as EBIT Multiple. This is an extremely useful indicator and like PE Ratio, it shows how many times a share price trades against earnings.

The difference between EBIT Multiple and PE Ratio is that EBIT Multiple takes into account distortions in earnings caused by cash holdings and borrowings, while PE Ratio just lumps in everything.

If we were to use just the PE Ratio to measure a company’s valuation, we may overlook the true income generating power of its underlying business.

Example: UAC Berhad
UAC is listed on Bursa Malaysia under the Industrial Products sector. It manufactures fibre cement products and other building materials for the property and construction industries. For the last 2 years, UAC’s financial profile can be summarized as follows:

At the time of writing 4 August 2007, UAC’s share price is RM4.70 and it has 74.3 million issued shares, giving it a Market Cap of around RM349 million.

Earnings Per Share for the year ending 31-Dec-2006 was 41.6 sen, meaning that it is trading at 11.3 times earnings. This does not look excitingly cheap at face value.

However look at UAC’s balance sheet more closely and you will see that they have cash holdings of some RM177 million and no borrowings. If we were to exclude the impact of these cash holdings, we would see something like this:

EBIT = RM35.5 million
Enterprise Value = RM(349 – 177) million = RM172 million

EBIT Multiple = 4.8 times

What this means in theory is that we can buy the entire company at RM349 million and the company we buy has some RM177 million cash which we can draw out completely, implying that the net price we are paying for the business assets is only RM172 million. This RM172 million that we fork out should return us earnings of around RM35.5 million or around 21% return on capital. Now that starts to look a bit better!

Compare this approach to just looking at PE Ratio. Under the PE Ratio approach, you would be looking at Net Profit After Tax of RM30.9 million divided by Market Cap of RM349 million, ie a return of only 8.9% on your capital. This low return is distorted by the company’s excessive cash holding (which you can assume earns a minimal 3-4% return). Strip out this cash and all of a sudden your PE Ratio will come down to below 5 times. So the business assets looks a lot cheaper indeed!

EBITDA Multiple
EBITDA Multiple = EV / EBITDA

(EBITDA is Earnings before the impact of interest income, interest expense, tax expense, depreciation expense and amortization expense)

A commonly used variant is the EV/EBITDA ratio which also excludes the impact of depreciation and amortization expenses incurred by the company, on the basis that these are non-cash expenses.

Accounting policies require that Property, Plant and Equipment are to be depreciated over a finite life. Due to the nature of certain types of assets, such a policy is sometimes considered conservative because the equipment in question may last well beyond the depreciation period, meaning that this equipment can continue to be used to generate business income for an indefinite period (perhaps with a little maintenance). Likewise accounting policies require that intangible assets such as goodwill or intellectual property be amortized over a finite life, while the actual reality is that the value of such intangibles may well increase over time because management successfully utilizes such assets to increase business earnings over time. Therefore under certain scenarios you may also wish to look at EBITDA Multiple to assess whether a company is cheap or expensive.