Knowledge Centre
Enterprise Value (EV) and EV to EBITDA
Enterprise value (EV) is a company's total value. It includes in its calculation the market capitalisation of a company but also short-term and long-term debt as well as any cash on the company's balance sheet.
MC = Market capitalisation; the current share-price multiplied by the number of outstanding shares.
EV = MC + Total Debt − C
Total debt = Equal to the sum of short-term and long-term debt
C = CashM and cash equivalents plus the liquid assets
EV is a popular metric used to value a company for a potential takeover because when evaluating the value of a takeover, the value of a firm's debt, for example, may need to be paid off by the buyer. It also takes into account the cash a company may have. Market capitalisation alone does not include these two potentially significant additions.
However, EV does not tell you how efficiently the company is using the debt. For example, an oil company is very capital intensive, and typically uses a lot of debt to finance this capital expenditure to generate revenue growth. EV is skewed positively towards companies with larger debt to those with less. Comparisons should therefore be made on a sector or industry basis.
EV becomes more useful when applying some form of valuation multiple. For example, EV divided by EBITDA (earnings).
At TEAM we apply EV/EBITDA to companies within the same sector or industry.
- The ratio may be more useful than the P/E ratio when comparing firms with different levels of debt.
- EBITDA is useful for valuing capital-intensive businesses with high levels of depreciation and amortisation.
- EBITDA is usually positive even when earnings per share (EPS) may not be.
However, EV/EBITDA also has a number of drawbacks:
- If the company’s working capital is growing, EBITDA will overstate cash flows from operations. It also ignores how different revenue recognition policies can affect a company.
- Because free cash flow includes capital expenditure valuation theory other than just EBITDA can be more applicable, such as book value or PEG. EBITDA works if capital expenses equal depreciation expenses.