Enterprise value (EV) is a concept we have discussed in previous posts. This is a financial metric in which you try to determine what is the current value of a company based on its market cap, debt, minority interest and preferred shares, minus cash and cash equivalents. This metric is designed to determine exactly how much a company is worth as it is currently operating; in other words, its function is to see how much investment a company needs to produce earnings.
This is why enterprise multiples are popular amongst investors. This is when you compare the EV to another metric, usually a type of earnings. And there are many types of earnings—net earnings, earnings before taxes, and EBITDA—earnings from continuing operations before removing interest, tax, depreciation, and amortization.
EBITDA is used because it removes the accounting magic that many firms’ CFOs employ to boost net earnings. Often, things like depreciation and tax can be manipulated easily, and they can vary tremendously from one period to another. With EBITDA, we don’t worry about that.
So using an EV/EBITDA ratio, we can see exactly how much money the company is earning and how much investment the company needs to earn it.
A lower ratio is better: it means the company requires less investment to produce earnings. For instance, a company with an EV of 5 and an EBITDA of 5 (thus an EV/EBITDA 1) has less value than a company whose EV is 5 and an EBITDA of 10 (EV/EBITDA=0.5).
To look at this in practice, let’s see the EV/EBITDA ratio of two stocks: Nike (NKE) and Under Armour (UA).
These companies compete in the same spaces: footwear, sports apparel, wearable technology. Both have adapted to technological change at a very quick pace thanks to significant investment—this will be important later.
So let’s look at the EV/EBITDA ratio of the two firms:
Clearly, Nike is much better at making money with less investment than UA, and has been able to do so for the last 5 years. More worryingly, UA’s EV/EBITDA has been both volatile and growing immensely in the last three years.
Now, back to the technological change issue. Keep in mind that these companies invest in research and development for new products, and the wearables market is both a buzzword and an important market for these companies as well as Fitbit (FIT), Google (GOOG) and Apple (AAPL). It’s an intense competition.
Some questions to ponder, then, as we see UA’s EV/EBITDA ratio rise. How does its investment in tech compare to Nike’s? How does this impact the company’s EV? Finally, what will this mean for the company’s future EBITDA and how should we incorporate our understanding of investments into the enterprise when projecting the future EV/EBITDA of these two firms?