Q&A: Forecast or current net debt in EV multiples?

When calculating a prospective enterprise value multiple based on say a year 2 or year 3 forecast profit metric how should the debt component of EV be measured? Should EV be current market capitalisation combined with the current net debt or should the forecast net debt for the same period as the profit metric be used?

From AB

August 2021

The Footnotes Analyst

Our view is that both approaches are valid.

Using a spot EV (current market capitalisation plus current net debt1Of course EV includes other components – see our article Enterprise value: Calculation and mis-calculation for guidance on calculating the different components of enterprise value)compared with a forward profit estimate is fine. It is no different from a PE ratio. 

A partial forward EV (current market capitalisation plus forecast net debt) has the advantage of capturing differences in free cash flow generation. Companies with higher cash flow appear cheaper on account of the greater debt pay down. This difference in multiple makes sense and helps to identify valuation differences. However, this effect can sometimes be misleading and is not necessarily comparable.

Suppose companies in a sector have different dividend policies. Those stocks with higher dividend payouts (or a policy of share buybacks) will have a smaller debt pay down and therefore will appear to be more expensive based on a prospective partial forward multiple. But this apparent cheapness is an illusion. 

Partial forward works well when the debt pay down differences are due to differences in free cash flow generation but less well when debt pay down differs for other reasons such as dividends, buybacks or forecast acquisitions.

A more comparable approach is to use full forward pricing as described in our article Why you should ‘forward price’ valuation multiples. Forward pricing directly takes into account how the free cash flow is utilised therefore resolves the problem above and also takes into account the time value of money. The resulting multiples are comparable between companies and over time (which is not the case for spot or partial forward pricing).

The problem with full forward pricing is the increased complexity of calculation and the need for a cost of capital input. It is also unusual and probably unfamiliar to most investors.

There is no perfect answer!