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 figure based on past costs. Enterprise value is built from market values and adds debt to the equity value instead of subtracting liabilities from assets.
Enterprise value is the value of the whole operating business to everyone who funds it. Formula: Enterprise value = Market value of equity + Debt - Cash. Cash is taken off because it could be used to pay the debt down. For example, equity of $800 million, debt of $300 million and cash of $100 million gives 800 + 300 - 100 = $1,000 million. In practice, preferred shares and non-controlling interests (other owners' stakes in subsidiaries) are also added when present.
A harder one
Orrin Robotics has 90 million shares outstanding at $28.00, debt of $1,100 million and cash of $320 million. Its EBITDA is $440 million. Comparable companies trade at a median EV/EBITDA of 8.2x. Sofia Mendes, an equity analyst, wants to judge how Orrin is priced relative to its peers. What is Orrin's EV/EBITDA multiple, and how does it compare with the peer median?
- 9.0x, a premium to the peer medianWhy not: Cash has been added to enterprise value instead of deducted (2,520 + 1,100 + 320 = 3,940). Enterprise value nets cash against debt, so adding it overstates the multiple and flips the verdict.
- 5.7x, a discount to the peer medianWhy not: Equity value (market capitalisation) was divided by EBITDA. EBITDA is earned before interest, so the numerator must include debt and exclude cash; the shortcut gives a multiple that is too low.
- 7.5x, a discount to the peer median - correct
EV/EBITDA = Enterprise value / EBITDA, where EBITDA is profit before interest, tax, depreciation and amortisation. Market capitalisation = 90 million x $28.00 = $2,520 million. Enterprise value = Market capitalisation + Debt - Cash = 2,520 + 1,100 - 320 = $3,300 million. EV/EBITDA = 3,300 / 440 = 7.5x. That is below the peer median of 8.2x, so Orrin trades at a discount. Dividing market capitalisation alone by EBITDA gives 5.7x, ignoring lenders' claims. Adding cash gives 9.0x, a false premium. A discount may reflect weaker growth or heavier spending needs, so it is a starting point, not a buy signal.
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 is also missing from EBITDA, but it is not what separates these two companies; the question is about capital intensity.
- The difference in revenue growthWhy not: Growth is not captured directly by any single-period multiple, and it is not specific to capital intensity.
- The reinvestment each one requires - correct
EBITDA is profit before spending on plant and equipment, so the multiple ignores how much cash a business must reinvest to keep going. Cash left over is roughly: EBITDA - Capital expenditure. For example, both companies earn EBITDA of $100 million. One spends $10 million a year, leaving 100 - 10 = $90 million for investors. The other spends $70 million, leaving 100 - 70 = $30 million. Same multiple, very different cash. A free cash flow measure shows this better.
In the app: 15 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
Take the free diagnostic →