Enterprise value multiples

What is enterprise value?

The enterprise value (EV) of a firm is its value to all its claimants, not only shareholders. It starts from the market capitalization (share price times shares outstanding) and adds the market value of debt and of preferred shares. It then subtracts cash and short-term investments.

$$EV = \text{MV of debt} + \text{MV of equity} + \text{MV of preferred shares} - \text{Cash and short-term investments}$$

In practice, the book value of debt as a proxy for market value is common, and the same goes for preferred shares. Cash and short-term investments are subtracted because they are cash as a non-operating asset : a buyer of the business would get them. Never add them. The firm value is the market value of debt plus the market value of equity, without the cash deduction.

$$\text{Firm value} = \text{MV of debt} + \text{MV of equity}$$

Enterprise value (EV)value of the business to all claimants

• Market value of equity Memorize price × shares outstanding
• plus Market value of debt Memorize book value often used as a proxy
• plus Market value of preferred shares Memorize a senior claim
• minus Cash and short-term investments Memorize non-operating assets; never add them

The pairing rule decides which multiples make sense. This is price versus EV multiples : EV goes with figures that belong to lenders and shareholders together (revenue, earnings before interest and taxes (EBIT), EBITDA, free cash flow to the firm (FCFF), which includes after-tax interest to lenders, and book value of capital). Market value of equity goes with figures that belong to shareholders (dividends, free cash flow to equity, net income, book value of equity).

Learning Module 5 introduced EV as equity plus preferred shares plus net debt.

How do you keep EV up to date after a change in capital structure?

Prices change daily, but debt and cash come from the last statements. Update EV for any financing announced since: that is the idea of EV after a change in capital structure .

Exam tip A buyback paid with new debt reshuffles the claims: EV stays put until prices move.

How do multiples on operating income and sales work?

Operating earnings belong to lenders and shareholders, so they pair with EV. That makes EV multiples useful for comparing firms with different financing. Three definitions matter. EBIT is earnings after depreciation and amortization but before interest and taxes. EBITDA adds depreciation and amortization back, and is a broader, non-standardized measure. Earnings before interest, taxes, and amortization (EBITA) adds back only amortization.

Denominator	Use when
EBITDA	depreciation and amortization are large and policies differ, as in capital-intensive businesses
EBITA	amortization of intangibles is a major expense but depreciation is not
EBIT	neither depreciation nor amortization is a major item
Sales	earnings are negative or volatile; with significant debt use enterprise value to sales (EV/sales) rather than price-to-sales (P/S)

EV/EBITDA controls for differences in depreciation and amortization practices, so it is frequently used for capital-intensive businesses with substantial depreciation and amortization. EV/EBITA and EV/EBIT follow the same logic with the charges that matter. EV/sales divides EV by revenue and replaces P/S when a firm carries significant debt.

The justified EV/EBITDA follows from constant growth. EV is next year’s FCFF divided by the weighted average cost of capital (WACC) less growth, and FCFF is EBITDA(1 − t) + depreciation × t − capital expenditures − the change in working capital. Divide by EBITDA:

$$\frac{EV}{\text{EBITDA}} = \frac{(1 - t) + \dfrac{\text{Dep} \times t}{\text{EBITDA}} - \dfrac{\text{Capex}}{\text{EBITDA}} - \dfrac{\Delta \text{WC}}{\text{EBITDA}}}{\text{WACC} - g}$$

Lower WACC, lower capital spending, higher growth and lower taxes all raise it. The tax effect is mixed: a lower rate raises the first term but shrinks the depreciation tax shield.

Why can the same price-to-earnings ratio hide different EV/EBITDA?

A price multiple and an EV multiple can tell different stories, because leverage and cash sit between them. When they disagree, look at the debt, the cash and the gap between operating income and net income.

Which balance sheet multiple copes with leverage?

When peers have different leverage, or a firm has negative book equity, the price-to-book ratio (P/B) breaks down. Compare the market value of all capital with its book value instead. The value to book multiple uses debt and equity at market and at book. The enterprise value to book multiple also deducts cash from both.

$$\text{Value to book} = \frac{\text{MV equity} + \text{MV debt}}{\text{BV equity} + \text{BV debt}}, \quad \text{EV to book} = \frac{\text{MV equity} + \text{MV debt} - \text{Cash}}{\text{BV equity} + \text{BV debt} - \text{Cash}}$$

For the justified form, write FCFF as EBIT × (1 − t) × (1 − the reinvestment rate). The reinvestment rate is the share of after-tax EBIT put back into depreciation-replacing and new capital spending and working capital. The return on capital (ROC) is next year’s after-tax EBIT divided by the book value of capital. Divide EV = FCFF ÷ (WACC − g) by book value of capital and you get the justified EV to book value of capital .

$$\frac{EV}{\text{Book value of capital}} = \frac{\text{ROC} \times (1 - \text{Reinvestment rate})}{\text{WACC} - g}$$

What about cash flow and industry-specific multiples?

The EV/FCFF multiple pairs EV with next year’s FCFF. Under constant growth the value to FCFF is one divided by the gap between WACC and growth. It suits firms with stable FCFF and swings with capital spending and working capital.

$$\frac{V_t}{\text{FCFF}_{t+1}} = \frac{1}{\text{WACC} - g}$$

For example, WACC of 8% and growth of 3% give 20.0.

Some sectors use industry-specific multiples , which divide by an operating measure such as output, reserves or users. Their advantages are a direct link to what drives value in the sector and no accounting distortions. Their drawbacks are no comparison with other industries (a whole sector can be mispriced against the market) and a weak link to fundamentals. Sorvik Gas has an EV of USD 4,800 million and developed reserves of 400 million barrels of oil equivalent, so its EV/developed reserves is 4,800 ÷ 400 = USD 12.00 per barrel to compare with other producers. Oil and gas analysts also use EV/production , EV per unit of daily output.

Which EV multiple suits which company?

Multiple	Driven by	Suits
EV/EBITDA	tax rate, depreciation, capital spending, WACC, growth	capital-intensive firms
EV/EBIT or EV/EBITA	as EV/EBITDA, after the charges that matter	firms where amortization (EBITA) or neither charge (EBIT) is large
EV/sales	margins, capital spending	loss-making or leveraged firms
EV to book value of capital	return on capital	firms with different leverage or negative book equity
EV/FCFF	FCFF growth, WACC	firms with stable FCFF
EV per unit of output or reserves	sector value drivers	commodity producers and other single-driver sectors

EV multiplespair EV with figures for all capital providers

• Income statement Memorize EV/EBITDA, EV/EBITA, EV/EBIT, EV/sales
• Balance sheet Use it value to book, EV to book value of capital
• Cash flow Know the idea EV/FCFF = 1 ÷ (WACC − g) when justified
• Industry-specific Know the idea EV per unit of output or reserves

Go deeper Why P/S and EV/sales can disagree

Sales belong to lenders and shareholders, so a heavily indebted firm looks cheap on P/S because its equity is a thin slice of the business. EV/sales puts the debt back. For an early-stage firm funded almost only by equity the two say nearly the same thing.