Corporate and Project Finance Modeling

Chapter 35Computing an Implied EV/EBITDA Ratio in Terminal Value Calculations

Chapter 34 explains that if there were no taxes and no capital expenditures and if there was no net debt, the price/earnings (P/E) ratio and the enterprise value/earnings before interest, taxes, depreciation, and amortization (EV/EBITDA) ratio would be the same. This implies that if you want to compute the implied EV/EBITDA ratio, the fundamental factors of growth, return, and cost of capital will drive the ratio just as they do for the P/E ratio. As depreciation, taxes, and debt are the factors that cause differences between the EV/EBITDA ratio and the P/E ratio, these factors must also be accounted for when computing the implied EV/EBITDA ratio.

To establish the implied EV/EBITDA ratio rather than the implied P/E ratio from all of the factors that drive enterprise value, including return, growth, cost of capital, tax rate, plant life, working capital, and tax depreciation, must be considered. The process of making a financial model to simulate the EV/EBITDA ratio involves creating a balance of net invested capital rather than the equity balance. Chapter 24 explains that invested capital can be calculated using either the balance of net assets associated with generating EBITDA or, alternatively, a balance of financing obligations including equity and net debt devoted to financing EBITDA. The model for computing the EV/EBITDA ratio works best using the direct method that begins with the asset side ...