Wednesday, June 28, 2006

An Important Ratio

Many financial/personal finance magazines tend to highlight only a few particular financial ratios. The most talked about one is the P/E ratio. This tends to be something that is easy to understand and has been widely used for years. It also tends to be a financial ratio that can be manipulated by management (i.e.- managing earnings). This is one reason why some people also use other ratios like the P/S (price to sales) ratio because Sales are a little harder to manipulate.

While these ratios are important, another important ratio is EV/EBITDA
Lots of letters there, so let's get through it:
EV stands for Enterprise Value. Think of the enterprise value as the amount someone would need to pay to takeover the company. It's a relatively easy ratio to compute: take the stock's market capitalization (price x shares), add in debt, add in preferred stock, then subtract out cash and cash equivalents.
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization
This figure eliminates the effects of financing. For most income statements, you can see the value if you take sales and subtract out cost of goods sold and selling/admin expenses.

Now we just have to put everything together. Take the enterprise value and divide that by EBITDA. A "good" number is something under 10. Basically the lower the number, the more the stock is considered a value play.

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