First, let’s understand what is EV.
EV is the total price that you need to pay to acquire 100% of any company.
It can be simply calculated as:
EV = Market Capitalization + Market value of Debt - Cash & cash equivalents
EV is the total price that you need to pay to acquire 100% of any company.
It can be simply calculated as:
EV = Market Capitalization + Market value of Debt - Cash & cash equivalents
Let’s understand with an example:
2 companies X & Y have the same market capitalization, while company X has a debt of 500 and Y with no debt. Both companies operate on 0 cash. EV of x would be higher.
2 companies X & Y have the same market capitalization, while company X has a debt of 500 and Y with no debt. Both companies operate on 0 cash. EV of x would be higher.
This signifies that the debt component impacts the Enterprise value. Meaning debt increases the purchasing cost of a company thereby making it more expensive.
Why EV is important?
EV includes the debt component which makes it easy for us to compare the capital structure of diff companies which is a crucial factor while analysing.
EV is often used in multiples such as EV/EBITDA, EV/FCF & EV/Sales.
EV includes the debt component which makes it easy for us to compare the capital structure of diff companies which is a crucial factor while analysing.
EV is often used in multiples such as EV/EBITDA, EV/FCF & EV/Sales.
Let’s understand these multiples.
1⃣EV/EBITDA gives us the picture of what we need to pay to acquire a company as a proportion to the earnings.
Lower the ratio better it is since it would mean higher earnings & higher possibility of returns.
1⃣EV/EBITDA gives us the picture of what we need to pay to acquire a company as a proportion to the earnings.
Lower the ratio better it is since it would mean higher earnings & higher possibility of returns.
2⃣EV/FCF is the total valuation of the company relative to its ability to generate cash flows. Lower ratio is better because it indicates fast cash flow generation which can be reinvested into the business.
3⃣EV/Sales accounts for debt component that needs to be paid back. Lower the ratio, the more attractive & undervalued the company is.
However, EV has many limitations too!
→ If the firm invested too much in unprofitable businesses. This will increase the debt in the books making the company overvalued. Thus, EV will give a false idea abt the company.
→ If the firm invested too much in unprofitable businesses. This will increase the debt in the books making the company overvalued. Thus, EV will give a false idea abt the company.
→ EV multiple can be used to compare 2 or more companies only when all the companies belong to the same industry because the capital structure & requirements tend to be diff for diff industries.
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