EBITDA | Stocks and bonds | Finance & Capital Markets | Khan Academy

In the last couple of videos
we saw that looking just purely at market capitalization
can be a little bit misleading, when you look at
companies that have a good bit of leverage or companies
that have a good bit of debt. For example, if that's the
assets of the company, and let's say that they have
this much debt. And this is their equity. And then let's say they
have some excess cash. Cash that's not necessary to
actually operate the business. I'll draw that up here. So this is excess cash. Some cash is necessary, and
oftentimes people don't make the distinction. And they'll just view this
as all the cash. But we really want to separate
the value of the enterprise out of the market value
of the equity or the value of the debt. So let me just write
all this down. So this right here, this is
the value of the business. The enterprise value.

Here is the debt. There's the debt. And this is the equity. And this is a little bit of
a slight, I would say, technicality. And you don't have to worry
about this if it confuses you at all. When I write the enterprise
here, this is the value of the business itself. So it's kind of the operational
assets net of the operational liabilities. It's literally– if you had
to go out in the past two examples and buy the pizzeria–
how much net would you have to pay for
that pizzeria? And that's what we're trying to
figure out right here when we're talking about the
enterprise value. And we saw in the last couple
of videos how you calculate it, but it never hurts
to review it. This is actually one of those
less intuitive calculations the first few times you
see it, so it doesn't hurt to do it again. So the first thing to figure out
is, how do you figure out the market value
of the equity? The book value of the
equity is very easy. You could go into a company's
balance sheet and they'll write down a number.

They'll say, this is what our
accountants say that the book value of our equity is worth. But the market value, figure it
out from what the market's willing to pay for a share. So the market value of equity or
the market cap is equal to price per share times the
number of shares. And that's the market value
of this equity. And you can see, just even from
this diagram, that the enterprise value plus the
non-operating cash or investments or liquid
investments, whatever you want to call them. Enterprise value plus the cash
is equal to the debt plus, let's just say the market cap.

Because we want to know, when we
look at a price, we want to be able to figure out what
is the market saying the enterprise value of
the company is? What is the market value
of the enterprise? So debt plus– instead of
equity– I'll write market capitalization, because
it's the same thing. Market capitalization is the
market's value of the equity plus market cap. So we know market cap. We can look up the debt on a
company's balance sheet. We can look up the cash. So we just subtract cash from
both sides, and we get enterprise value is equal
to market cap plus debt minus cash. We're just taking cash
onto the right-hand side of this equation. So for example, if I have a
stock that is trading at- let's say the price is $10. And let's say that there
are 1 million shares. And let's say that the company
has $50 million of debt.

And let's say it has $5 million
of excess cash, what's its enterprise value? Well, you first figure
out its market cap. Its market cap is $10 per share
times a million shares. So that's 10 million shares. That's the market cap. You add the debt. So, plus $50 million. And once again, I said this in
the last video, it's very unintuitive when you figure
out the value of the enterprise to add the debt. And the intuition is that if
someone were to want to buy this company from the
stakeholders and be debt free, they would have to pay these
people the total amount of debt, and they'd have to pay
these people the total amount of the market value.

So they'd have to pay the
debt plus the equity. And they get a refund
of the cash. This would be extra stuff that
they would be buying that they could get money back for. So you have to pay the equity
holders, you have to pay the debt holders, and then you
get a refund of the cash. And so the enterprise value's
what? $60 million minus 5. That's $55 million. Fair enough. This is all just review of the
enterprise value video. But the question is, now that
you've figured out enterprise value, how do you figure
out if that's a fair enterprise value? When you looked at market
capitalization you compared that to earnings. The price to earnings ratio. You were doing this
on a per share. This is price per share divided
by earnings per share. This ratio's equivalent to
market cap divided by the actual net income
of the company. Where if you just multiply the
numerator and the denominator by the number of shares, you get
market cap and net income. This is EPS. P/E is actually price
per share divided by earnings per share. And that was one way
to look at it.

You could compare
two companies. And we saw it breaks down if
they have different types of capital structure. So what do you compare
enterprise value to? Here we did market cap
to net income. Enterprise value should
be compared to what? Now I made an argument in the
last video that, well if we're looking at the enterprise, we
should look at essentially the earnings that are popping
out of the enterprise. We should look at the earnings
that are coming out of this asset right here. And on the very first video
on the income statement, I implied that– let's do
a balance sheet– you have your revenue.

Your revenue could be 100. You have your cost
of goods sold. Cost of goods sold could be,
let's say it's minus 50. And I'll show you another
convention. One of the commenters suggested
that I do this convention. Which is actually the most
typical convention for a lot of accountants and financial
analysts. Instead of writing a negative,
they'll write it in parentheses. That means negative. Minus 50. And then the gross profit
would be 50.

And then, actually I want to
do something a little bit interesting. Let's say that this cost of
goods sold, it involves no depreciation or amortization. And watch those videos if
those words confuse you. And all of the appreciation and
amortization is actually occurring at the corporate
level. So let's say that there
is some SG&A. But this is without the
depreciation and amortization. So let's say that this
is an expense of 10. Let's say there's some
depreciation and amortization as well. D&A. In the last couple of videos
I kind of grouped. And that tends to be the case. On a lot of income statements
they won't separate out the depreciation and amortization. And you'll actually have to
look at the cash flow statement to figure
out what this is.

And I'm going to do that
in a future video. But let's say that we actually
do break it out. Sometimes that does happen. And let's say that
that's another 5. Maybe these are in thousands. And then you're left with
the operating profit. In this case, which is 50
minus 15, so it's 35. And then you have things
below that. You have interest. And I'll do
those just for– you have the non-operating income and
interest and all that. Let me just do that. Interest. Let's say that that is
also 5,000, if that's what we care about.

And then you have pre-tax. I didn't put the non-operating
income. Let's say this cash isn't
generating anything. So pre-tax income is 30,000,
if that's what we're dealing with. It's getting a little messy. So then you have taxes. Let's say it's 1/3. It's 10,000 of taxes. And then you have earnings. 30 minus 10 is 20,000. So I suggested, what part of
this income statement is dependent purely on this
piece right here? Well all this stuff with
interest, that's dependent on the debt. And essentially taxes is also
dependent on the debt. Because the more interest
you have, the more you can deduct it. And so all of this down
here is dependent on your capital structure. So if you wanted to look just
what the enterprise value is generating, it's generating
the operating profit.

So I suggested that a pretty
good ratio, although this is very non traditional. It's not very not traditional,
but you don't hear it said a lot. I'd argue that you could look at
EV to operating profit as a good metric. Which in a lot of cases is the
inverse of the return on assets, as I defined it
in the first video. There's a lot of different
return on asset definitions. But it's essentially saying, for
every dollar of operating profit, how much are you paying
for the enterprise. Which I think is a pretty
good metric. Now, the more conventional
metric that you'll see when you see people talk about
enterprise values, enterprise value to EBITDA. And if you go and get a job as
a research analyst at some firm, this is going to be
something that you're going to be expected to calculate
for a company. And hopefully talk reasonably
intelligently about it. So the first question, to talk
reasonably intelligently about anything is, what is EBITDA? So EBITDA is Earnings Before
Interest, Taxes, Depreciation and Amortization. So let's see what that
would be here.

So it's earnings before
interest, taxes, depreciation and amortization. So it's before all
of this stuff. Actually, let's compare that to something we covered before. So you have EBITDA. And you have EBIT. EBIT is Earnings Before
Interest and Taxes. So EBIT is earnings. You add back taxes and
interest. You're at operating profit. And I've gone over this in the
past, but the distinction between operating profit and
EBIT is that EBIT might include some non-operating
income, which I haven't put here. But if this cash was generating
some profit unrelated to the operations
of the business, it'd be included in EBIT. It wouldn't be an operating
profit. But they're usually pretty close
if we're talking about, let's say, a non-financial
type of business. So this is EBIT. And if you want to get EBITDA,
you just add back the depreciation and amortization. So EBITDA would be here. So the EBIT is 35,000. If you add that back,
it would be 40,000.

So the EBITDA in this
case is 40. And if my units are in
thousands, it's 40,000. Now the question is, why do
people care about EBITDA? Why is EBITDA used instead
of operating profit? And the logic is that
depreciation and amortization, and we did this in the
depreciation and amortization videos, these are just
spread-out costs that necessarily aren't cash going
out the door in this period. We saw that this depreciation
and amortization. Maybe this is, I bought
a $100 or $100,000 object 10 years ago. And every year I depreciate
1/20 of it. But the cash went out the
door 20 years ago. And so this depreciation and
amortization in this period, it isn't necessarily cash
out of the door. In fact, it isn't cash
out the door. We'll talk in future videos
about how do you find out what the cash out the door
is in a period. So it's considered a
non-cash expense. So when you figure out EBITDA,
when you add back taxes, you add back interest, and you
add back depreciation and amortization. What you're left with is
essentially, how much raw cash is the enterprise
spitting out? And a lot of people care about
this because this is an indication of, one,
the company's ability to do things.

To do things like pay its
interest, pay its taxes, or invest in the business itself. Or another way to view it is,
if you look at EV to EBITDA, you're saying for every dollar
of raw cash that this business spits out. And let's say I were not to
reinvest in the business or buy new equipment. If it's just raw dollars, how
much am I paying for the enterprise? And a general rule of thumb, and
we'll do more on this in the future.

I think I'm already well over my
regular time limit, is that for a very, stable, simple,
non-declining non-growing business, five times EBITDA is
considered a good valuation. But what matters more is what
other companies in that industry are trading at. So all of these ratios
are better as relative valuation metrics. In the future I'll show you how
to do maybe a discounted cash flow or a discounted free
cash flow type of analysis. Or a dividend discount model or
something, so you can kind of figure out an
absolute value.

But when you're looking in
public markets, when you're picking to decide something,
you're also implicitly picking not to buy other things. When you're choosing to sell
something, you're also implicitly choosing not
to sell other things. So relative value starts to
matter a little bit more. Anyway, hopefully you
found that helpful..

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