Enterprise Multiple

Enterprise multiple, also known as the EV multiple, is a ratio used to determine the value of a company. The enterprise multiple looks at a firm in the way that a potential acquirer would by considering the company's debt. Stocks with an enterprise multiple of less than 7.5x based on the last 12 months (LTM) is generally considered a good value. However, using a strict cutoff is generally not appropriate because this is not an exact science. 

Unlike many other common measures, the enterprise multiple takes into account a company's debt and cash levels in addition to its stock price and relates that value to the firm's cash profitability (e.g. the price-to-earnings [P/E] ratio).

Where:

• EV = (market capitalization) + (value of debt) + (minority interest) + (preferred shares) - (cash and cash equivalents); and
• EBITDA is earnings before interest, taxes, depreciation, and amortization.

Investors mainly use a company's enterprise multiple to determine whether a company is undervalued or overvalued. A low ratio indicates that a company might be undervalued and a high ratio indicates that the company might be overvalued.

An enterprise multiple is useful for transnational comparisons because it ignores the distorting effects of individual countries' taxation policies. It's also used to find attractive takeover candidates since enterprise value includes debt and is a better metric than market cap for mergers and acquisitions (M&A). A company with a low enterprise multiple can be considered as a good takeover candidate.

Enterprise multiples can vary depending on the industry. It is reasonable to expect higher enterprise multiples in high-growth industries (e.g. biotech) and lower multiples in industries with slow growth (e.g. railways).

The enterprise multiple is computed by divided enterprise value by EBITDA. EBITDA is an acronym that stands for earnings before interest, taxes, depreciation and amortization. However, the measure is not based on U.S. generally accepted accounting principles (GAAP). In April 2016, the Securities and Exchange Commission (SEC) stated non-GAAP measures such as EBITDA would be a focal point for the agency to ensure that companies are not presenting results in a misleading manner. If EBITDA is shown, the SEC advises that the company should reconcile the metric to net income. This should assist investors by providing information on how the figure is calculated.

Enterprise value (EV) is a measure of the economic value of a company. It is frequently used to determine the value of the business if it is acquired. It is considered to be a better valuation measure than market capitalization, since the latter factors in only a business' equity without regard to the debt. EV is calculated as the market capitalization plus debt, preferred stock, and minority interest, minus cash. An entity purchasing a company would have to pay the value of the equity and assume the debt, but the cash would reduce the price paid.

Because the enterprise multiple includes assets, debt and equity in its analysis, a company's enterprise multiple provides an accurate depiction of total business performance. Equity analysts use the enterprise multiple when making investment decisions.

For example, Denbury Resources Inc., a petroleum and natural gas company based in Texas, reported its first-quarter financial performance on June 24, 2016. Denbury Resources had an enterprise value-to-adjusted-EBITDA ratio of 5x and a forward enterprise multiple of 13x. Both enterprise multiples were compared to other industry companies with past company multiples. The company's forward enterprise multiple of 13x was more than double the enterprise value from the same period in 2015. Analysts found that the increase was due to an expected decline in the company's EBITDA by 62%.

Enterprise multiples provide an easy shorthand for identifying companies that are well-valued. But, beware of value traps, stocks with low multiples because they are deserved (e.g. the company is struggling and won't recover). This creates the illusion of a value investment, but the fundamentals of the industry or company point toward negative returns.

Investors tend to assume that a stock's past performance is indicative of future returns and when the multiple comes down, they often jump at the opportunity to buy it at such a "cheap" value. Knowledge of the industry and company fundamentals can help assess the stock's actual value.

One easy way to do this is to look at expected (forward) profitability (EBITDA) and determine whether the projections pass the test. Forward multiples should be lower than current LTM multiples; if they are higher, it generally means the profits will be declining and the stock price is not yet reflecting this decline. Sometimes forward multiples can look extremely inexpensive. Value traps occur when these forward multiples look overly cheap, but the reality is the projected EBITDA is too high and the stock price has already fallen, likely reflecting the market's cautiousness. As such, it's important to know the company's and industry's catalysts.