1. Enterprise vs Equity Mulitple
So we spend a lot of time discussing enterprise value versus equity value,
but we haven't really discussed valuation multiples, however, we can still
use multiples and look at a practical example and see how
there might be differences in multiples. So on the tab EV versus Equity
Multiples, we have two companies, Company A, Company B, you can see their
income statement, you scroll down, you have a simplified balance sheet.
Company A and Company B are identical companies in every way,
with the exception of debt, Company A has much more debt.
Zoom in a little bit. And due to that lower debt burden,
we assume that Company B will have a greater market cap.
Now, admittedly, this is a simplification and may not necessarily hold in
the real world. But since we're pretending these companies are identical
except for the debt, then it works for our purpose.
So let's now calculate net debt for each company as well as enterprise
value, now in the simplistic example, there is no cash, so net debt
is just debt for each company. So we'll do Company A
has the higher debt burden, we'll just reference their $20,000 in debt
and then for Company B, do the same, they have $2000 in debt.
And again, just for simplicity, we're ignoring cash,
so to calculate enterprise value, market cap plus net debt, so we can
just sum those up, fill it to the right and we have an
enterprise value of $180,000 for each company, that should make sense.
Its enterprise value is the value of the company's operations, and these
companies are identical other than capital structure and enterprise value
is capital structure neutral. Now, let's pull in the EBITDA,
and EBITDA is also capital structure neutral. So we have the same EBITDA.
We calculate enterprise value to EBITDA, EV to EBITDA multiple,
and we get 8.6 times for both Company A and Company B.
Now, let's take a look at the price to earnings multiple,
since we have different market caps, and because Company A has a lot
more interest expense, the net income, which is a leverage metric,
meaning it does take into account capital structure, the net income will
be lower for Company A then it will be for Company B.
So we can reference Company A and then we can fill to the
right to get Company B's net income, of course, the "fill right" shortcut
is Control R. There we can take our market cap,
divided by net income, we have our price to earnings multiple,
again, and fill that to the right. And in this case,
you can see that the multiple is different, of course, it's different for
two different reasons, there's differences in market cap,
because those are both leverage metrics. There's differences in net income,
because Company A pays a lot more interest expense, so we would expect
to see differences in price to earnings in this case,
'cause again the only difference between these two companies is the debt.
Enterprise value is capital structure neutral, so the enterprise value
and the enterprise value to EBITDA multiple should be the same.
The price to earnings, however, market cap is after debt, that income is
after paying interest expense, so the price to earnings multiples will be
different.
2. Let's practice!