EBIT/EV Multiple

The EBIT/EV multiple is a financial ratio used to measure a company's "earnings yield." EBIT stands for earnings before interest and taxes, while EV is enterprise value. The concept of this multiple as a proxy for earnings yield was introduced by Joel Greenblatt, a noteworthy value investor and professor at Columbia Business School.

Enterprise value is market capitalization + debt + minority interest + preferred stock - cash. For the vast majority of companies, since minority interest and preferred stock in the capital structure is uncommon, EV is market cap + debt - cash. If EBIT/EV is supposed to be an earnings yield, the higher the multiple, the better for an investor. Thus, there is an implicit bias towards companies with lower levels of debt and higher amounts of cash. A company with a leveraged balance sheet, all else equal, is riskier than a company with less leverage. The company with modest amounts of debt and/or greater cash holdings will have a smaller EV, which would produce a higher earnings yield.

The EBIT/EV ratio can provide a better comparison than more conventional profitability ratios like return on equity (ROE) or return on invested capital (ROIC). While the EBIT/EV ratio is not commonly used, it does have a couple of key advantages in comparing companies. First, using EBIT as a measure of profitability, as opposed to net income, eliminates the potentially distorting effects of differences in tax rates. Second, using EBIT/EV normalizes for effects of different capital structures. Greenblatt states that EBIT "allows us to put companies with different levels of debt and different tax rates on an equal footing when comparing earnings yields." EV, to Greenblatt, is more appropriate as the denominator because it takes into account the value of debt as well as the market capitalization. A downside to the EBIT/EV ratio is that it does not normalize for depreciation and amortization costs. Thus, there are still potential distorting effects when companies use differing methods of accounting for fixed assets.

Say Company X has EBIT of $3.5 billion, market capitalization of $40 billion, $7 billion in debt, and $1.5 billion in cash. Company Z has EBIT of $1.3 billion, market cap of $18 billion, $12 billion in debt, and $0.6 billion in cash. EBIT/EV for Company X would be approximately 7.7% while the earnings yield for Company Z would be approximately 4.4%. Company X's earnings yield is superior not only because it has greater EBIT, but also because it has lower leverage.