Company’s enterprise value to earnings before interest, taxes, depreciation, and amortization.
In addition to the P/E ratio and PEG ratio, investors can also use enterprise value to EBITDA to evaluate whether a company is expensive or not. Enterprise value can be defined as the cost of the company to another investor who would want to buy it. In our previous analysis in determining whether a company is expensive or not, those ratios did not take into account debt but the enterprise value does.
Enterprise Value
We can use the enterprise multiple to calculate whether a stock is expensive or not but we need to determine the enterprise value first. This value indicates what the company is worth and if there was a takeover, what it would cost to acquire the company.
This calculation is as follows:
Enterprise Value: Market Capitalization + Market Value of Debt – Cash and equivalents
Market capitalization
This is calculated by taking the number of company’s outstanding shares and multiplying it by the current market price. However just using the shares alone is not an accurate reflection of what the company is worth. This is because we need to take into account the market value of debt, and cash and equivalents.
Preferred Shares
These are hybrid securities with debt and equity characteristics. However, they are treated as debt instruments in acquisitions as they have a fixed dividend and higher priority than shares.
Market Value of Debt
The debt of a company is defined as outstanding debt which can be short term debt and long term debt. When a company is purchased, the buyer also takes on the existing debt which is why this figure is included in the enterprise value calculation.
Cash and equivalents
When a company is purchased, the acquirer also receives what cash the company owns. This cash could be used to pay off existing debts. It is subtracted from the enterprise value as it can decrease the cost to pay to buy the company.
Using Enterprise Value to evaluate companies
With the results of the enterprise value we can use this data to evaluate the value of a company and therefore determine how expensive a company is by calculating the enterprise multiple.
Stocks that have a lower multiple are usually better value than a company with a higher multiple. Enterprise multiples can be compared between different companies and the industry average to determine whether a company is expensive.
Enterprise Multiple = EV/EBITBA
EBITDA ratio is the earnings before interest, taxes, depreciation and amortization.
This enterprise multiple looks at the firm’s stock price and takes into account debt and cash reserves. It compares it to the firm’s earnings before interest depreciation and amortization.
Example
Company Purple
Enterprise Value : $4,500,000,000
EBITBA : $500,000,000
Enterprise Multiple : 9 x
Company Blue
Enterprise Value : $600,000,000
EBITBA: $100,000,000
Enterprise Multiple : 6 x
This figure indicates this company Purple is more expensive than company Blue as the multiple is higher.
Lauren Hua is a private client adviser at Fairmont Equities.
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