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.
EBITDA (earnings before interest, taxes, depreciation, and amortization) can be viewed as a source of funds to pay off the financial stakeholders in the company (lenders, shareholders, the government, etc.). EV/EBITDA is arguably the most common EV multiple. The EV/EBITDA ratio for S&P 500 companies has averaged 13 over the past few years. As a general guideline, an EV/EBITDA value below 10 is commonly interpreted as healthy by analysts. Since EBITDA is usually positive even when net income is negative, EV/EBITDA can be calculated when a price-to-earnings (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 2018. The analyst accidentally used the company’s 2017 book value of debt ($200 million) instead of the 2018 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.
Correctly increasing EBITDA by $25 million would, in fact, decrease the calculated EV/EBITDA for Confuzzled, Inc.
Option A is incorrect. 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.
Option B is incorrect. 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.
Reading 41 LOS 41k:
Describe enterprise value multiples and their use in estimating equity value