###### Using P/Es to Obtain Terminal Value in ...

When estimating the terminal value, analysts use price multiples such as P/Es... **Read More**

Enterprise value multiples are relatively less sensitive to the financial leverage effects relative to price multiples when one is comparing companies that use different amounts of leverage. In addition, they take a control perspective.

EBITDA is defined as an estimate of pre-interest, pretax operating cash flow. At the same time, enterprise value is total company value (the market value of common equity, debt, and preferred equity) minus the value of cash and short-term investments. EV/EBITDA is, therefore, a valuation indicator for the overall company.

- EV/EBITDA is more appropriate than P/E alone for comparing companies with different financial leverage values (debt values).
- Adding back depreciation and amortization eliminates issues that arise from the different methods of accounting for depreciation unlike net income, which is post depreciation and post amortization.
- EBITDA is positive when EPS is negative.

- EBITDA overestimates cash flow from operations when working capital is growing.
- Free cash flow to the firm (FCFF) has a stronger link to valuation theory than EBITDA.

$$\begin{align*}\text{Enterprise value}& = \text{Market value of common equity}\\& + \text{Market value of preferred stock} +\text{Market value of debt}\\&- \text{Value of cash and short-term investments}\end{align*}$$

The justified EV/EBITDA based on fundamentals is positively related to the expected profitability as measured by return on invested capital, and the expected growth rate in free cash flow to the firm. It is negatively related to the business’s weighted average cost of capital. Return on invested capital (ROIC) is computed as operating profit after tax divided by total invested capital.

A lower EV/EBITDA relative to peers shows that a company is relatively undervalued. However, EV/EBITDA is one piece of information to consider. Total invested capital (TIC), also known as the market value of invested capital, is an alternative to enterprise value. It is the market value of equity and debt.

Other enterprise value multiples include:

- EV/FCFF.
- EV/EBITDAR. Where R stands for rent expense.
- EV/EBIT.

Enterprise value to sales is an alternative to the price to sales ratio. The P/S multiple weakness is that it fails to recognize that for a debt-financed company, not all sales belong to a company’s equity investors. Some of the proceeds from the company’s sales will be used to pay interest and principal to the company’s debt capital providers. EV/S is an alternative sales-based ratio that is particularly useful when comparing companies with diverse capital structures.

$$\small{\begin{array}{l|r}\text{Number of shares outstanding} & \text{100,000}\\ \hline\text{Market price per share} & 16 \\ \hline\text{The market value of preferred stock} & 1.2 \\ \hline\text{The market value of debt} & 2.8 \\ \hline\text{Cash and short-term investments} & 0.6 \\ \hline\text{Revenues} & 6.4 \\ \hline\text{Depreciation and amortization expense} & 0.5 \\ \hline\text{Interest expense} & 0.1 \\ \hline\text{Taxes} & 0.3 \\ \hline\text{Net income} & 1.9\\\end{array}}$$

Calculate enterprise value, EBITDA, and EV/EBITDA.

$$ \text{Enterprise value} =(0.1\times16)+{1.2m}+{2.8m}-{0.6m}=\${5m} \\ \begin{align*} \text{EBITDA}&=\text{Net income}+\text{Interest}+\text{Taxes} \\ & +\text{Depreciation and amortization}\\&=1.9\ \text{m}+0.1\ \text{m}+0.3\ \text{m}+0.5\ \text{m}\\&=$2.8\ \text{m}\\ \frac{\text{EV}}{\text{EBITDA}}&=\frac{\$5\ \text{m}}{\$2.8\ \text{m}}\\&=1.79\end{align*}$$

## Question

A lower EV/EBITDA relative to peers indicates that a company is

mostly likely:

- undervalued.
- overvalued.
- fairly valued.
## Solution

The correct answer is A.A lower EV/EBITDA relative to peers most likely indicated that it is relatively undervalued.

B is incorrect.A higher EV/EBITDA value relative to peers indicates that the company is relatively overvalued.

C is incorrect.An EV/EBITDA value similar to that of peers indicates that the company is relatively fairly valued.

Reading 25: Market-Based Valuation: Price and Enterprise Value Multiples

*LOS 25 (n) Calculate and interpret EV multiples and evaluate the use of EV/EBITDA.*