Enterprise value: Our preference for valuation multiples

Enterprise value multiples allow for better comparisons where capital structure differs and they provide a clearer focus on the core business. EV multiples also more reliably capture the cost of debt finance and other non-common stock claims; the amount reflected in net income and earnings per share can be out of date and incomplete.

Although they are generally our preferred approach, EV multiples present computational challenges that are not present in equity multiples. All valuation multiples have limitations and are less rigorous than full discounted cash flow analysis.

A valuation multiple expresses a measure of value relative to a key metric, such as a measure of profitability, cash flow or even underlying assets. Most such metrics are presented in, or derived from, financial statements.  In this article we are not going to discuss the merits or shortcomings of metrics such as EBITDA, free cash flow or earnings, but rather whether the measure of value used in the multiple should be equity value (the stock price) or enterprise value (the more comprehensive measure related to the business as a whole).

Enterprise value versus equity value

  • Equity value: An equity multiple relates the value of the shareholders’ interest in the business to a results metric that applies to only the common shareholders and is stated after deducting the costs related to other forms of finance. The most commonly used equity multiple is, of course, the price earnings ratio.
  • Enterprise value: EV multiples express the value of an entire business enterprise, as represented by the value of all claims on the business, relative to a results metric that relates to that entire enterprise, such as post-tax operating profit (NOPAT), EBIT or EBITDA. The financial claims that make up enterprise value include common equity (market capitalisation), other equity claims such as non-controlling interests and equity derivatives, debt finance including lease obligations and any other debt-like liabilities such as pension obligations. EV is also generally measured on a ‘core’ or operating basis where the value of non-core assets and excess cash are deducted.

The key difference between equity and enterprise value multiples is the treatment of non-common share claims, investments and non-core assets. The cost or benefit of these items is reflected in enterprise value multiples in absolute terms, whereas for equity multiples the annual cost or benefit must be included in the respective profit or cash flow metric. For example, the claims that non-controlling shareholders have on earnings is deducted when calculating the EPS used for a PE ratio. However, for an EV multiple there is no such deduction from profit, but instead the value of the claim held by non-controlling shareholders is added as part of enterprise value.

Both approaches are valid. What matters is whether information is available to appropriately measure the required components of each calculation. In practice, determining both the absolute value of the components of enterprise value, and the annual profit or cash flow consequences, presents challenges. The accounting information available to do each calculation is incomplete and often out of date, being invariably based on historical costs rather than the more relevant fair values.

Enterprise value multiples are worth the added effort … as long as they are calculated correctly

In terms of their ease of calculation equity multiples win hands down because both the stock price and earnings per share are readily available. Enterprise value multiples require much more effort and analysis. Only the equity value component of EV is straightforward. The challenge of calculating EV multiples, and what can go wrong, is something that we highlighted in our article EV/EBITDA multiples must be consistent: Novartis.

There are several situations where a PE ratio will not provide you with a solid basis to make comparisons. Enterprise value multiples provide a clearer focus on the core business and do not suffer from the distortion that can arise from differences in capital structure, non-core assets and investments.

Leverage effect makes PE ratios less comparable

Perhaps the most significant difference between equity and enterprise value multiples is the way in which leverage is incorporated. Differences in leverage have little effect on EV multiples given the focus on pre-financing metrics. This results in greater comparability between companies with different capital structures. Using EV multiples also makes it easier to compare valuation multiples over time if financing changes.

For equity multiples, leverage can have significant impact. Higher leverage tends to result in lower equity multiples. This is not because the stock is inherently cheaper but simply due to the mathematics of leverage.

Take an example of two companies with identical business activities, one that has surplus cash and the other debt finance. Assuming that no value is created through a different financing mix, then enterprise value would also be the same, resulting in identical EV multiples – we use the ‘unlevered’ version of P/E – EV/NOPAT. However, the P/E ratios are very different. In this situation it is difficult to use P/E as a basis to assess relative value.

Illustration of the PE ratio leverage effect
Note: The irrelevance of capital structure for the value of the business may not be entirely correct given taxation and other market imperfections, but this does not impact our message.

We think that enterprise value multiples are more relevant in situations where financial leverage differs. Equity multiples have to be interpreted both in light of the quality of the underlying business and also considering differences in financial risk.

Capturing the current cost of debt is easier with enterprise value

Debt and other debt-like claims, such as pension or environmental obligations, reduce the value of the underlying business that accrues to equity investors. This is reflected in equity and enterprise value multiples in different ways. Equity multiples incorporate an interest charge, whereas EV multiples include the fair value of the liability in the EV itself. If the interest expense is consistent with the fair value of that debt, and reflects a fair cost, then the two types of multiples would be consistent and equally valid However, there are challenges for both.

For enterprise value multiples to correctly represent value, the current fair value of the claim needs to be included in EV. For most debt instruments this does not represent a problem. This is because, although the liability is likely to be reported at historical cost in the balance sheet, companies are required to disclose fair value. But for other debt-like liabilities, such as environmental obligations, obtaining a realistic current value may be more challenging. Although the balance sheet amount is required to be measured using up-to-date cash flows and discount rate, the rate applied may not always be consistent with the principles of fair value. For an example, see our article on measuring environmental obligations – When investors need to restate liabilities.

However, in our view, equity multiples present a greater challenge because the interest included in net income reflects historical cost measurement and does not necessarily approximate a current interest expense. There is no disclosure of what that current interest expense would be, making adjustment very difficult.

We think that enterprise value multiples better reflect the true cost of debt-like financing.

Equity multiples fail to reflect the economic value of equity derivatives

Equity derivatives, such as share warrants or employee options, and equity derivatives embedded in other sources of finance, such as convertible bonds, represent a financial claim that should be included in enterprise value at an estimated fair value. This particularly matters for derivative instruments where the intrinsic value can differ quite significantly from the total fair value.

Diluted EPS does not capture the full cost of equity derivatives

In a price earnings ratio, the cost of equity derivatives is included through the use of a diluted earnings per share (assuming diluted EPS is used – in practice its application is inconsistent). Although diluted EPS is better than basic EPS for the purpose of a PE ratio, it does not capture the full economic cost of dilutive securities. This is because the share-count adjustment used for diluted EPS only allows, in effect, for the intrinsic value of equity derivatives. The EV calculation, on the other hand, incorporates the much more relevant absolute fair value (as long as EV is calculated correctly).

For example, if a company issues at-the-money share warrants then, for the purpose of an EV multiple, the issue price (and subsequently the fair value) would be included in enterprise value. The impact on the multiple depends on what the company does with the capital raised, but if we assume the proceeds are used to repay debt then the net effect on EV is zero. As pre-financing profit metrics are also unaffected so are EV multiples. This is the correct answer, since merely raising and repaying finance at fair value does not in itself create or alter value.

However, because the warrant is ‘at-the-money’, the diluted EPS calculated under the treasury stock method would be the same as basic EPS in our example and the cost of the warrant would be entirely omitted, resulting in a misleading PE ratio.

An illustration: Assume a company has an equity market capitalisation of 1000, being 1000 shares each with a price of 1.00. The only other claim on the business is share warrants. The company has 250 warrants, each with an exercise price of 1.00. The fair value is 0.30 per warrant and hence 75 in total. The net income and also NOPAT of the company is 100. Because the exercise price of the warrants is the same as the current stock price the security would not be regarded as dilutive when applying the treasury stock method of calculating diluted EPS as specified by IAS 33. Therefore, the resulting EV and equity multiples are:

EV/NOPAT = (1000 + 75) / 100 = 10.75x

P/E ratio = 1000 / 100 = 10.0x

The price earnings ratio fails to capture the true burden that common shareholders suffer as a result of the written options. They have given up part of their upside if the business does well but none of their downside if the opposite is true. Only the enterprise value multiple correctly reflects this.

It is possible to make adjustments to the calculation of diluted EPS to better reflect the economic value of equity derivatives. The treasury stock method could be modified to reflect fair value, not intrinsic value, or a profit attribution approach could be used.

Investors need the disclosure of the fair value of equity derivatives

The problem for investors is that there is presently no requirement to disclose the fair value of equity derivatives in financial statements. This makes both the calculation of a valid enterprise value and equity value based multiples challenging. Some may argue that the dilution calculation at least captures intrinsic value, which is better than nothing. Nevertheless, we still think that enterprise value is the best approach and that investors should make the effort to investigate and incorporate the fair value of equity derivatives where they are material.

Non-controlling interests, non-core assets and investments

There are a number of other elements where a ‘flow’ is included in equity multiples, but an absolute measure is reflected in enterprise value.

Non-controlling interests

Price earnings ratios incorporate the interests of non-controlling shareholders in subsidiaries by using the profit attributable to just the parent shareholders. This is not a problem as long as the non-controlling interest is in subsidiaries that are representative of the group as a whole. If, for example, the NCI applies to an early stage start-up venture, then the PE ratio will be, in effect, the weighted average of a lower multiple for the parent shareholders’ interest in the business and a higher multiple for the NCI.

An EV approach should be superior because it allows for the separate valuation of non-controlling interest in subsidiaries that would incorporate their specific characteristics.

Non-core assets and investments

The implied multiple attributable to non-core assets and investments can be very different from those applicable to the core operations of a business. In effect, a PE ratio is a weighted average of these two multiples and consequently is less comparable than a core EV multiple. Even worse, for some investments the return could be omitted from the income statement entirely, such as equity investments accounted for at fair value through other comprehensive income (only dividends and ‘realised’ gains appear in net income, which may well be zero in any given period). Where material, this could have a severely distorting effect on a PE ratio. Enterprise value solves this by incorporating the fair value of the investments in the calculation of the core EV itself.

We consider the issue of the reporting of equity investments in OCI in our article Ignore this recycled profit – Ping An. In our view it is the current fair value of such investments that should be of primary interest for investors, and not what happens to be reported in the income statement or OCI. For this reason, we think that EV multiples are much more useful where such investments are significant.

Why enterprise value?

We prefer enterprise value multiples because they:

  • Are more comparable where companies have significant differences in leverage or where leverage changes over time.
  • Allow for the fair value of debt claims in enterprise value rather than capturing in earnings a debt expense that is generally based on historical cost.
  • Include the full cost of dilutive securities compared with the incomplete diluted earnings per share.
  • Can better cope with non-core assets and investments that have different characteristics compared with ‘core’ operations.
  • Can be applied to a wider range of key metrics and are easier to apply to cash flow measures.
  • Are not affected by accounting choices that only influence the profit impact of items included in EV, for example, the transition discount rate option in IFRS 16.
  • Better capture the effect of those items for which gains and losses are reported in OCI rather than earnings.

Equity multiples have their uses. They are easier to apply given that they avoid the need to separately calculate enterprise value.  Missing out components, not correctly measuring those components at fair value and inconsistencies with the selected profit metric are all potential pitfalls when calculating EV.

The issues we identify above do not always apply and if leverage is not significantly different and there are no other distorting effects present, then equity multiples and the commonly used price earnings ratio can work just as well. However, perhaps the greatest benefit of equity multiples is their familiarity. Most investors have a good feel for PE ratios and there is a long historical dataset to draw on.

Enterprise value multiples are superior – but potentially not the commonly used EV/EBITDA

There is a tendency for investors to focus on EV / EBITDA when using enterprise value multiples. We do not think this is the best use of enterprise value. In our view, tax, depreciation and (some) amortisation are items that affect value and should not be missed. The more comprehensive NOPAT measure, or NOPAT adjusted to include maintenance capital expenditure in place of D&A, are superior.

All valuation multiples, whether based on equity or enterprise value, have their limitations. Basing value on a single metric for a single period is clearly not as rigorous as using comprehensive discounted cash flow analysis. Although, EV multiples can be reconciled with DCF, as we demonstrate in our article Linking value drivers and enterprise value multiples, they are nevertheless simplified and should always be used with caution.

Insights for investors

  • Enterprise value multiples are more comparable and provide a better basis for relative value comparisons than multiples based directly on equity value.
  • Use diluted EPS in preference to basic EPS for PE ratios, but remember that the dilution does not fully capture the fair value of the claims of investors in equity derivatives.
  • Remember that enterprise value multiples require a realistic measure of enterprise value in the first place. Including book values of claims and investments is often not good enough. Be careful to ensure enterprise value is both complete and consistent with how you define the related performance metrics.
  • Valuation multiples are less rigorous than a more comprehensive discounted cash flow based analysis. Always be aware of their limitations.

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