The EV/EBIT ratio has the limitation of considering the amortization of intangible assets that are added to the balance sheet through mergers and acquisitions.
The key point is that such amortization almost does not affect future cash flows (since the asset does not actually wear out). Therefore, accounting for it typically distorts the picture.
In the table, three companies are presented. For growth purposes, the first company acquires the second, while the third grows organically. Before the merger, the combined operational results of the first two equal those of the third, making their EVs also par with each other.
After the merger, the accounts of A+B and C are almost identical, differing only in intangible assets and amortization. The write-off of such assets is a non-cash expense and does not impact future cash flows. Therefore, combining the two organizations yields the same operational result and does not affect the EV (assuming no synergetic effects).
As a result, the EBIT/EV parameter gives an inadequate picture, while EBITA/EV remains unchanged.
Why not EBITDA?
This is a good question because one might conclude that depreciation is also practically a sunk cost and does not affect future cash flows. However, this is not the case in many industries. The real wear and tear of tangible assets necessitates of capital reinvestments.
It is important to recognize that sales forecasts are linked to the volume and growth of net capital, and thus, the real wear and tear of tangible assets directly affects reinvestment rates.
Also, for example, imagine two companies: one uses its own production facilities, while the other outsources production. The first will have higher depreciation, but the second will have the supplier’s depreciation costs reflected in the purchased raw materials’ price. Thus, both companies would have the same operational result, but using EBITDA for comparison would lead to significant discrepancies.
Source:
#VALUATION – Measuring and Managing the Value of Companies, 7th Edition
McKinsey & Company,
Tim Koller, Marc Goedhart, David Wessels
