Enterprise value (EV), often viewed as the cost of a takeover, is most frequently determined as market capitalization plus the market value of preferred stock plus the market value of debt minus cash equivalents and short-term investments. EV/EBITDA (earnings before interest, taxes, depreciation, and amortization) is arguably the most common EV multiple. EBITDA can be viewed as a source of funds to pay off the financial stakeholders in the company (lenders, shareholders, the government, etc.). EBITDA is usually positive even when net income is negative, allowing for EV/EBITDA to be calculated when a P/E multiple may not be available. EV/Operating Income can also be used as an alternative to EV/EBITDA. Analysts may have difficulty finding the market value of a company’s debt, in which case the value may have to be estimated based on comparable bond values.
A junior analyst made a number of mistakes when performing an analysis of Confuzzled, Inc., a soft drink manufacturer as of year-end 2015. The analyst accidentally used the company’s 2014 book value of debt ($200 million) instead of the 2015 book value of debt ($150 million) when calculating relevant financial ratios. The analyst also overstated the company’s marketable securities by $20 million and understated EBITDA by $25 million. All else equal, the correction of which one of these errors on its own will cause a decrease in the analyst’s calculation for Confuzzled’s EV/EBITDA multiple?
A. Book value of debt
B. Cash equivalents
The correct answer is C.
The book value of debt should not be used in calculating enterprise value. Thus, the correction should have no effect on the EV/EBITDA multiple. In correcting the marketable securities error, cash equivalents would be reduced by $20 million causing a corresponding increase in enterprise value and, therefore, an increase in the EV/EBITDA multiple. Finally, correctly increasing EBITDA by $25 million would, in fact, decrease the calculated EV/EBITDA for Confuzzled, Inc.
Reading 49 LOS 49i:
Describe enterprise value multiples and their use in estimating equity value