What Is It?
The EV/EBITDA ratio is made up of two parts. The EV part stands for 'enterprise value' and is calculated by adding a company's market capitalisation, debt, minority interest and preferred equity, and subtracting cash and cash equivalents. The idea behind enterprise value is to provide an estimate of what it could cost to acquire a company, rather than simply use market capitalisation.
The second part of the EV/EBITDA ratio is 'earnings before interest, taxes, depreciation and amortization'. This is a line on the income statement that is stated after revenues have had expenses (except for interest, taxes, depreciation and amortization) deducted and provides an indication of a company's current level of profitability.
To calculate the EV/EBITDA ratio, we simply divide enterprise value by EBITDA.
Why Does It Matter?
The EV/EBITDA ratio is an important tool for investors in assessing whether shares in a company offer good value at current price levels, which can be a useful means of deciding whether an alpha opportunity exists. Judgment can be made on an absolute (i.e. standalone) basis, relative to sector/industry peers, or compared to historical EV/EBITDA levels for the stock in question. Advantages of using the EV/EBITDA ratio to assess a company's valuation include simplicity, ease of calculation and easy comparison versus other stocks.
What About Microsoft?
As you can see from the chart below, Microsoft's (NASDAQ:MSFT) EV/EBITDA ratio currently stands at 8.80, which is the highest it has been over the last year. This may cause some investors to feel that shares are now fully valued and that the ratio (and share price) should drop away to bring Microsoft back into its one year valuation range. However, we feel that Microsoft's EV/EBITDA ratio can break out of its one year range and make new highs as a result of the strong recent momentum that the chart shows. For instance, looking at the last few months shows a gradual uptick in the ratio and reduced volatility than was present prior to this period, which we feel bodes well going forward.
Furthermore, Microsoft's EV/EBITDA ratio has been far higher in the past than it is at present. Looking back over five years, as the chart below shows, highlights that back at the start of 2010 Microsoft's EV/EBITDA ratio was as high as 13. This is 47.7% higher than the current level and shows that there is scope for an increase. Indeed, we don't have to go as far back as 2010 to find a higher level, since the chart also shows that Microsoft's EV/EBITDA ratio reached above 9 as recently as early summer-2013. This highlights the potential, we feel, for Microsoft's valuation to rise above its current level.
However, perhaps the key reason why we feel Microsoft's EV/EBITDA ratio could rise is the current discount versus sector peer, Oracle (NYSE:ORCL). Although not a carbon copy of Microsoft, the two companies share the same sector and are of a vast size. Indeed, the chart below shows the two companies' EV/EBITDA ratios since the start of 2012. What fascinates us is that Microsoft's ratio nearly always trades at a discount to that of Oracle throughout the period, but that the two companies' ratios merge when the gap between them widens too much.
For example, in June 2012, the discount was 15.5% and was then narrowed to zero in July 2012. In March 2013 the discount was around 16% and was flipped so that Microsoft traded at a premium to Oracle by June 2013. Furthermore, in September 2013 the discount was around 13.5% and narrowed to around 2%. Today the discount is 7.6% which, while not as wide as the occasions highlighted, is beginning to narrow, as the chart shows. Therefore, we feel that there is scope for the gap to reduce to zero going forward.
What Does This Mean For Investors?
We believe that Microsoft could be undervalued at current levels and, as such, there could be an alpha opportunity. This is due to Microsoft's EV/EBITDA ratio being at a sizeable discount to that of sector peer, Oracle, with there being signs in recent weeks that the gap between the two is starting to narrow.
In addition, Microsoft's EV/EBITDA ratio has been far higher than its current level as recently as 2010. Indeed, even though it is at the top-end of its one year range, we feel that recent strong, stable, upward momentum shows that Microsoft's EV/EBITDA ratio can make higher highs. We believe that investors will continue to bid up the price of Microsoft's shares so as to increase its EV/EBITDA ratio.
Microsoft's current EV/EBITDA levels appear to offer an alpha opportunity for investors. We feel that the market will push Microsoft's EV/EBITDA ratio above one-year highs so that it is closer to highs from previous years. We are also of the opinion that the valuation gap between Microsoft and Oracle has started to narrow and we would expect this trend to continue. As such, we feel that Microsoft could make share price gains going forward.
Feedback request: What do you think of Microsoft? Would you buy, sell or hold right now? Please comment below!
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.