Work out multiples based on enterprise value and explain what they mean
The idea
Enterprise value is the market value of equity plus debt less cash, and represents the cost of acquiring the whole business. Dividing it by EBITDA gives a multiple comparable across companies with different capital structures, because both numerator and denominator are measured before financing. That is its advantage over the price-to-earnings ratio, which is distorted by leverage and is meaningless when earnings are negative. Its weaknesses are that EBITDA ignores capital intensity and working capital needs, so two companies at the same multiple may convert profit to cash very differently.
Formulas
Enterprise value
enterprise value = market capitalisation + debt − cash
- market capitalisation
- the price per share × the shares outstanding
- debt
- the market value of debt, including preferred stock
- cash
- cash and short-term investments
The cost of buying the whole business rather than the equity: the buyer takes on the debt and gets the cash. Because it is independent of how the company is financed it compares companies with different leverage, which a price-to-earnings ratio cannot.
A practice question
How is enterprise value calculated?
- Market value of equity plus total assetsWhy not: Double counts: the assets are what the equity and the debt already finance.
- Market value of equity plus debt less cash — correct
- Total assets less total liabilitiesWhy not: That is book equity, an accounting residual. Enterprise value is built from market values and adds the debt rather than subtracting it.
It represents what an acquirer would pay for the operating business: the equity, assuming the debt, net of cash that comes with it.
A harder one
Why is EV/EBITDA more comparable across companies than price-to-earnings?
- Because both numerator and denominator are measured before the effects of financing — correct
- Because EBITDA is audited and earnings are notWhy not: Reverses the reliability. Net earnings are the audited figure; EBITDA is a non-statutory measure assembled from them.
- Because enterprise value excludes intangible assetsWhy not: Enterprise value excludes nothing of the kind; it is a market figure and makes no distinction between tangible and intangible assets.
A highly levered and an unlevered company with identical operations have very different price-to-earnings ratios but similar EV/EBITDA, because leverage has been removed from both parts of the ratio.
The hardest tier
Two companies trade at the same EV/EBITDA but one is far more capital intensive. What does the multiple fail to capture?
- The difference in tax ratesWhy not: Tax sits below EBITDA too, but it is not what distinguishes these two: the question turns on capital intensity.
- The difference in revenue growthWhy not: Growth is missing from every multiple and is not specific to capital intensity.
- The reinvestment each one requires — correct
The capital-intensive company must reinvest much more of its EBITDA, so less reaches investors as cash. EBITDA sits before capital expenditure by construction: where reinvestment needs differ sharply, the same multiple represents very different economics and a free cash flow measure is more honest.
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