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EBITDA | Stocks and bonds | Finance & Capital Markets | Khan Academy - YouTube
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In the last couple of videos
we saw that looking just
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purely at market capitalization
can be a little
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bit misleading, when you look at
companies that have a good
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bit of leverage or companies
that have a good bit of debt.
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For example, if that's the
assets of the company, and
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let's say that they have
this much debt.
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And this is their equity.
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And then let's say they
have some excess cash.
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Cash that's not necessary to
actually operate the business.
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I'll draw that up here.
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So this is excess cash.
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Some cash is necessary, and
oftentimes people don't make
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the distinction.
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And they'll just view this
as all the cash.
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But we really want to separate
the value of the enterprise
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out of the market value
of the equity or the
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value of the debt.
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So let me just write
all this down.
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So this right here, this is
the value of the business.
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The enterprise value.
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Here is the debt.
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There's the debt.
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And this is the equity.
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And this is a little bit of
a slight, I would say,
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technicality.
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And you don't have to worry
about this if it
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confuses you at all.
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When I write the enterprise
here, this is the value of the
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business itself.
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So it's kind of the operational
assets net of the
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operational liabilities.
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It's literally-- if you had
to go out in the past two
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examples and buy the pizzeria--
how much net would
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you have to pay for
that pizzeria?
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And that's what we're trying to
figure out right here when
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we're talking about the
enterprise value.
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And we saw in the last couple
of videos how you calculate
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it, but it never hurts
to review it.
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This is actually one of those
less intuitive calculations
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the first few times you
see it, so it doesn't
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hurt to do it again.
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So the first thing to figure out
is, how do you figure out
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the market value
of the equity?
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The book value of the
equity is very easy.
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You could go into a company's
balance sheet and they'll
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write down a number.
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They'll say, this is what our
accountants say that the book
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value of our equity is worth.
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But the market value, figure it
out from what the market's
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willing to pay for a share.
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So the market value of equity or
the market cap is equal to
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price per share times the
number of shares.
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And that's the market value
of this equity.
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And you can see, just even from
this diagram, that the
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enterprise value plus the
non-operating cash or
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investments or liquid
investments, whatever you want
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to call them.
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Enterprise value plus the cash
is equal to the debt plus,
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let's just say the market cap.
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Because we want to know, when we
look at a price, we want to
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be able to figure out what
is the market saying the
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enterprise value of
the company is?
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What is the market value
of the enterprise?
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So debt plus-- instead of
equity-- I'll write market
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capitalization, because
it's the same thing.
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Market capitalization is the
market's value of the equity
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plus market cap.
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So we know market cap.
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We can look up the debt on a
company's balance sheet.
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We can look up the cash.
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So we just subtract cash from
both sides, and we get
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enterprise value is equal
to market cap
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plus debt minus cash.
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We're just taking cash
onto the right-hand
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side of this equation.
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So for example, if I have a
stock that is trading at-
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let's say the price is $10.
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And let's say that there
are 1 million shares.
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And let's say that the company
has $50 million of debt.
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And let's say it has $5 million
of excess cash, what's
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its enterprise value?
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Well, you first figure
out its market cap.
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Its market cap is $10 per share
times a million shares.
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So that's 10 million shares.
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That's the market cap.
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You add the debt.
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So, plus $50 million.
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And once again, I said this in
the last video, it's very
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unintuitive when you figure
out the value of the
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enterprise to add the debt.
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And the intuition is that if
someone were to want to buy
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this company from the
stakeholders and be debt free,
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they would have to pay these
people the total amount of
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debt, and they'd have to pay
these people the total amount
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of the market value.
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So they'd have to pay the
debt plus the equity.
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And they get a refund
of the cash.
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This would be extra stuff that
they would be buying that they
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could get money back for.
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So you have to pay the equity
holders, you have to pay the
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debt holders, and then you
get a refund of the cash.
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And so the enterprise value's
what? $60 million minus 5.
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That's $55 million.
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Fair enough.
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This is all just review of the
enterprise value video.
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But the question is, now that
you've figured out enterprise
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value, how do you figure
out if that's a
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fair enterprise value?
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When you looked at market
capitalization you compared
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that to earnings.
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The price to earnings ratio.
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You were doing this
on a per share.
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This is price per share divided
by earnings per share.
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This ratio's equivalent to
market cap divided by the
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actual net income
of the company.
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Where if you just multiply the
numerator and the denominator
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by the number of shares, you get
market cap and net income.
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This is EPS.
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P/E is actually price
per share divided by
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earnings per share.
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And that was one way
to look at it.
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You could compare
two companies.
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And we saw it breaks down if
they have different types of
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capital structure.
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So what do you compare
enterprise value to?
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Here we did market cap
to net income.
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Enterprise value should
be compared to what?
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Now I made an argument in the
last video that, well if we're
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looking at the enterprise, we
should look at essentially the
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earnings that are popping
out of the enterprise.
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We should look at the earnings
that are coming out of this
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asset right here.
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And on the very first video
on the income statement, I
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implied that-- let's do
a balance sheet--
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you have your revenue.
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Your revenue could be 100.
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You have your cost
of goods sold.
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Cost of goods sold could be,
let's say it's minus 50.
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And I'll show you another
convention.
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One of the commenters suggested
that I do this
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convention.
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Which is actually the most
typical convention for a lot
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of accountants and financial
analysts.
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Instead of writing a negative,
they'll write it in
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parentheses.
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That means negative.
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Minus 50.
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And then the gross profit
would be 50.
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And then, actually I want to
do something a little bit
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interesting.
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Let's say that this cost of
goods sold, it involves no
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depreciation or amortization.
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And watch those videos if
those words confuse you.
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And all of the appreciation and
amortization is actually
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occurring at the corporate
level.
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So let's say that there
is some SG&A.
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But this is without the
depreciation and amortization.
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So let's say that this
is an expense of 10.
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Let's say there's some
depreciation and
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amortization as well.
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D&A.
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In the last couple of videos
I kind of grouped.
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And that tends to be the case.
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On a lot of income statements
they won't separate out the
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depreciation and amortization.
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And you'll actually have to
look at the cash flow
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statement to figure
out what this is.
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And I'm going to do that
in a future video.
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But let's say that we actually
do break it out.
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Sometimes that does happen.
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And let's say that
that's another 5.
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Maybe these are in thousands.
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And then you're left with
the operating profit.
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In this case, which is 50
minus 15, so it's 35.
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And then you have things
below that.
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You have interest. And I'll do
those just for-- you have the
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non-operating income and
interest and all that.
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Let me just do that.
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Interest. Let's say that that is
also 5,000, if that's what
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we care about.
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And then you have pre-tax.
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I didn't put the non-operating
income.
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Let's say this cash isn't
generating anything.
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So pre-tax income is 30,000,
if that's what
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we're dealing with.
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It's getting a little messy.
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So then you have taxes.
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Let's say it's 1/3.
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It's 10,000 of taxes.
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And then you have earnings.
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30 minus 10 is 20,000.
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So I suggested, what part of
this income statement is
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dependent purely on this
piece right here?
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Well all this stuff with
interest, that's
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dependent on the debt.
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And essentially taxes is also
dependent on the debt.
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Because the more interest
you have, the more
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you can deduct it.
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And so all of this down
here is dependent on
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your capital structure.
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So if you wanted to look just
what the enterprise value is
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generating, it's generating
the operating profit.
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So I suggested that a pretty
good ratio, although this is
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very non traditional.
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It's not very not traditional,
but you don't
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hear it said a lot.
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I'd argue that you could look at
EV to operating profit as a
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good metric.
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Which in a lot of cases is the
inverse of the return on
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assets, as I defined it
in the first video.
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There's a lot of different
return on asset definitions.
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But it's essentially saying, for
every dollar of operating
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profit, how much are you paying
for the enterprise.
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Which I think is a pretty
good metric.
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Now, the more conventional
metric that you'll see when
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you see people talk about
enterprise values, enterprise
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value to EBITDA.
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And if you go and get a job as
a research analyst at some
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firm, this is going to be
something that you're going to
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be expected to calculate
for a company.
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And hopefully talk reasonably
intelligently about it.
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So the first question, to talk
reasonably intelligently about
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anything is, what is EBITDA?
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So EBITDA is Earnings Before
Interest, Taxes, Depreciation
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and Amortization.
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So let's see what that
would be here.
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So it's earnings before
interest, taxes, depreciation
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and amortization.
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So it's before all
of this stuff.
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Actually, let's compare that to
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something we covered before.
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So you have EBITDA.
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And you have EBIT.
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EBIT is Earnings Before
Interest and Taxes.
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So EBIT is earnings.
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You add back taxes and
interest. You're
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at operating profit.
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And I've gone over this in the
past, but the distinction
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between operating profit and
EBIT is that EBIT might
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include some non-operating
income, which
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I haven't put here.
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But if this cash was generating
some profit
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unrelated to the operations
of the business, it'd
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be included in EBIT.
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It wouldn't be an operating
profit.
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But they're usually pretty close
if we're talking about,
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let's say, a non-financial
type of business.
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So this is EBIT.
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And if you want to get EBITDA,
you just add back the
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depreciation and amortization.
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So EBITDA would be here.
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So the EBIT is 35,000.
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If you add that back,
it would be 40,000.
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So the EBITDA in this
case is 40.
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And if my units are in
thousands, it's 40,000.
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Now the question is, why do
people care about EBITDA?
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Why is EBITDA used instead
of operating profit?
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And the logic is that
depreciation and amortization,
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and we did this in the
depreciation and amortization
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videos, these are just
spread-out costs that
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necessarily aren't cash going
out the door in this period.
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We saw that this depreciation
and amortization.
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Maybe this is, I bought
a $100 or $100,000
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object 10 years ago.
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And every year I depreciate
1/20 of it.
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But the cash went out the
door 20 years ago.
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And so this depreciation and
amortization in this period,
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it isn't necessarily cash
out of the door.
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In fact, it isn't cash
out the door.
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We'll talk in future videos
about how do you find out what
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the cash out the door
is in a period.
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So it's considered a
non-cash expense.
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So when you figure out EBITDA,
when you add back taxes, you
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add back interest, and you
add back depreciation and
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amortization.
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What you're left with is
essentially, how much raw cash
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is the enterprise
spitting out?
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And a lot of people care about
this because this is an
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indication of, one,
the company's
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ability to do things.
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To do things like pay its
interest, pay its taxes, or
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invest in the business itself.
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Or another way to view it is,
if you look at EV to EBITDA,
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you're saying for every dollar
of raw cash that this
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business spits out.
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And let's say I were not to
reinvest in the business or
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buy new equipment.
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If it's just raw dollars, how
much am I paying for the
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enterprise?
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And a general rule of thumb, and
we'll do more on this in
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the future.
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I think I'm already well over my
regular time limit, is that
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for a very, stable, simple,
non-declining non-growing
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business, five times EBITDA is
considered a good valuation.
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But what matters more is what
other companies in that
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industry are trading at.
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So all of these ratios
are better as
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relative valuation metrics.
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In the future I'll show you how
to do maybe a discounted
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cash flow or a discounted free
cash flow type of analysis.
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Or a dividend discount model or
something, so you can kind
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of figure out an
absolute value.
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But when you're looking in
public markets, when you're
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picking to decide something,
you're also implicitly picking
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not to buy other things.
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When you're choosing to sell
something, you're also
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implicitly choosing not
to sell other things.
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So relative value starts to
matter a little bit more.
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Anyway, hopefully you
found that helpful.
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