Enterprise Value (EV) & Calculating Enterprise Value Ratios

by KenFaulkenberry

in Investment Analysis

Enterprise Value - Total Value of a Company

Enterprise Value - Total Value of a Company

Enterprise value (EV) and Enterprise value ratios are part of the basic foundation of stock analysis for value investors.

The purpose of Enterprise Value (EV) is two fold; First, to calculate what it would cost to purchase the entire company or business. Secondly, to provide a capital neutral valuation with which to compare with other companies. Comparisons can be make with Enterprise Value and with Enterprise Value Ratios which will be explored later in this post.

Enterprise Value Calculation

Enterprise Value (EV) = Market Capitalization + Total Debt – Cash

In order to calculate the total value of a business a buyer would take market capitalization (#of shares x stock price) plus all debt (preferred shares, minority interest, etc), and subtract cash. In other words EV is, in theory, the total price of buying a company.

An acquirer would be liable for the debts of a company, making purchasing the company more expensive. Therefore, debt increases the cost of purchasing a company, and is an addition in the  enterprise value calculation. Cash would be an asset that could offset debt or be absorbed by the acquirer, so it is a subtraction in the enterprise value calculation.

Total Value of a Company

Many investors get confused between the different metrics that represent the total value of a company:

1.. Book Value is the accounting value of the company as determined by the balance sheet of the company’s financial statements. However, the stated values on the balance sheet might be significantly different than the market value.

2. Market Capitalization is the total value of a company’s equity. It is calculated by multiplying the number of equity shares outstanding by the price of the stock. It completely ignores debt capital.

3. Enterprise Value (EV) best represents the total value of a company because it is includes equity and debt capital, and is calculated using current market valuations.

Enterprise Value and Market Capitalization

A company with more cash than debt will have an enterprise value less than its market capitalization. A company with more debt than cash will have an enterprise value greater than its market capitalization.

Example of Difference

Companies with identical market capitalizations can have radically different enterprise values. Company A may have considerable debt and little cash, while Company B might have little debt and considerable cash.

________Market Cap.  + Debt      – Cash       =  EV

Company A:  5 billion  +  5 billion  -  1 billion =  9 billion EV

Company B:  5 billion  +  0 billion  -  2 billion = 3 billion EV

Both companies have a 5 billion dollar market capitalization but Company A has an enterprise value of 9 billion and Company B an enterprise value of 3 billion. When comparing company A to company B, company A is riskier than company B (everything else being equal) because it has a high amount of debt. Also, company A would have to provide a much higher return in dollars to compensate for its high value and greater risk.

Why is Enterprise Value Important?

The value investor should have this mindset: When you buy a stock you are buying a percentage share of the whole company. Enterprise value is the current market price if you were purchasing the entire company. Why would you value a company differently just because you are buying only a percentage?

Enterprise Value (EV) measures the value of the assets that produce the company’s product or service. In other words, it as an economic value that includes the equity capital (market capitalization) and debt capital (liabilities) of the enterprise.

The fact that enterprise value makes allowances for debt and cash provides a neutral metric for calculating EV ratios. EV ratios can provide key insights and comparisons between companies despite the fact that the companies may have large  differences in capital structure.

Calculating Enterprise Value (EV) Ratios

1.  EV/EBIT

EV/EBIT = Enterprise Multiple = Enterprise Value / Earnings Before Interest & Taxes

(When comparing similar companies, a lower enterprise multiple would be a better value or bargain than a higher multiple.)

or turn the ratio around to get the yield…

Earnings Yield  = Enterprise Value / Earnings Before Interest & Taxes / Enterprise Value (EBIT / EV)

(When comparing similar companies, a higher earnings yield would indicate a better value or bargain than a lower yield.)


Example: Company XYZ has an enterprise value of  5 billion and an EBIT of 500 million.

EV/EBIT = $5,000,000,000 / 500,000,000  = 10 multiple

EBIT/EV = $5,000,000 / $5,000,000,000 =  10% yield

The earnings yield is half of the “Magic Formula” popularized by Joel Greenblatt. This EV ratio is similar to the more popular price to earnings ratio (P/E ratio) but with two important differences. First, Greenblatt uses enterprise value instead of market capitalization. Second, he uses Earnings Before Interest & Taxes (EBIT) instead of earnings. These two changes allow the analyst to contrast companies with different capital structures on an equal basis by removing the biases of debt and cash.

Tobias Carlisle, in his book Deep Value (affiliate link) does an outstanding job of dissecting the magic formula (pages 58- 69) and explaining how the earnings yield (a.k.a the enterprise multiple) is an exceptional value investing ratio.

2.  EV/EBITDA

EV/EBITDA = Enterprise Value / Earnings Before Interest Taxes Depreciation & Amortization

(When comparing similar companies, a lower enterprise multiple would be a better value or bargain than a higher multiple.)

or turn it around to get the yield…

EBITDA Earnings Yield = Earnings Before Interest Taxes Depreciation & Amortization / Enterprise Value (EBITDA/EV)

(When comparing similar companies, a higher earnings yield would indicate a better value or bargain that a lower yield.)

Example: Company XYZ has an enterprise value of  5 billion and an EBITDA  of 650 million.

EV/EBIT = $5,000,000,000 / 650,000,000  = 7.7 multiple

EBIT/EV = $650,000,000 / $5,000,000,000 =  13% yield

3. EV/CFO

EV/CFO = Enterprise Value / Cash From Operations

EV/CFO = Market Capitalization + Total Debt – Cash / Operating Income (Revenue – Cost of Sales) + Depreciation & Amortization – Taxes +/- Change in Working Capital

(When comparing similar companies a lower multiple would be a better value or bargain than a higher multiple.)

or turn the ratio around to get the yield…

Cash Flow From Operations Yield = Cash Flow From Operations / Enterprise Value (CFO / EV)

(When comparing similar companies a higher CFO / EV yield would indicate a better value or bargain than a lower yield.)

Example:  Company XYZ has an enterprise value of 5 billion and CFO of  600 million.

EV/CFO =  5,000,000,000 / 600,000,000 = 8.3 multiple

CFO/EV =  600,000,000 / 5,000,000,000 = 12% yield

Cash Flow From Operations (CFO) a.k.a Operating Cash Flow (OCF) is a better valuation metric than profits because it is unaffected by accounting entries such as depreciation and amortization, or cash flows from financing or investing activities.

The EV/CFO ratio will tell you how many years it would take to buy the entire company if you could use all the cash from operations for the purchase.

(Note: For analysis of most companies I use the CFO definition that includes interest as an operations expense and therefore a reduction in cash from operations.)

4.  EV/FCF

EV/FCF = Enterprise Value / Free Cash Flow

(When comparing similar companies, a lower enterprise multiple would be a better value or bargain than a higher multiple.)

or turn it around to get the yield…

Free Cash Flow Yield = Free Cash Flow / Enterprise Value (FCF/EV)

(When comparing similar companies, a higher earnings yield would indicate a better value or bargain than a lower yield.)


The next two ratios would be secondary in importance to the above ratios. That doesn’t mean they are not useful. It just means they would usually be used in limited situations or when an analyst wants even deeper value comparisons between companies:

5.  EV/Sales

EV/Sales = Enterprise Value / Sales (Revenues)

The EV/Sales ratio provides the analyst the relationship between sales and the cost of buying the company. In other words, it tells you the total cost of buying the company sales.

6.  EV/Assets

EV/Assets = Enterprise Value / Assets

For the investor looking for cheap assets, the EV/Assets ratio provides an additional metric with which to look for bargains.

Conclusion

Enterprise value is a key metric for value investors because it best represents the total value of a company and is capital structure neutral. EV can be used for calculating enterprise value ratios that provide important comparisons between companies.


Written by KenFaulkenberry

KenFaulkenberry

AAAMP Blog by Ken Faulkenberry
Ken Faulkenberry earned an MBA from the University of Southern California (USC) Marshall School of Business with an emphasis in investments. Ken has 25 years of investment experience and is dedicated to helping people with self-directed investment management through the Arbor Investment Planner. His asset allocation strategies have an outstanding performance record.
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