What are enterprise valuations?

An enterprise value tell you how much a buyer would have to pay to buy a company as a whole, not just the equity part of it. To calculate a company's EV you need the following bits of financial information about a company:

• Its market capitalisation (the market value of its equity) - this is simply the current number of shares in issue multiplied by the current share price.
• Total borrowings - this can be found on a company's balance sheet.
• The total value of cash and cash equivalents. Again this can be found on the balance sheet.
• The value of any preferred equity shares (preference shares). This can be a balance sheet value or a market value of the preference shares traded on a stock exchange.
• The value of any pension fund deficit. These are real, debt-like liabilities that any buyer would have to take on or pay off. Again, this number can be found on a balance sheet.
• Minority interests - the amount of equity that does not belong to the company's shareholders. Minority interests occur when a company owns more than 50% but less than 100% of a business.

EVs can be seen as a total market valuation of a company's assets.

How to use EVs

The important thing to remember when you are using multiples to look at the value of companies is that the numerators and denominators of them must match up.

So price multiples which concern the equity of a company must be matched with corresponding returns:

The same applies for EV multiples. Because EVs are all about the market values of equity and debt they must also be matched with the corresponding returns: the sales, pre-interest profits and free cash flows that accrue to both lenders and shareholders.

If you don't match up the right numbers then you are effectively comparing apples with oranges. For example price/EBITDA per share or EV/net profit.

Taking this on board, it is possible to calculate the following EV multiples:

• EV/EBITDA
• EV/EBIT
• EV/FCFf
• EV/NOPAT (Debt-adjusted PE)
• EV/Sales
• EV/Capital Employed
• Earnings power value (EPV)/EV

SharePad can do all of these calculations for you. Just as with price multiples, the lower the number, the cheaper the valuation of a business and the cheaper its shares are deemed to be.

As with price multiples, they can be calculated on a trailing/historic basis using reported numbers or on a forecast basis (where forecast values are available). This article uses reported numbers.

Always remember that low valuations can often be a sign of a poor quality business and do not make very good long-term investments. Conversely, higher valuations associated with high quality businesses which have good growth prospects can be very good investments.

Let's take a look at these EV multiples in turn by using them to analyse the value of the UK food retailing sector.

If you are a less-experienced investor, don't worry if you get a bit bogged down. Pick one or two of these ratios and try using them alongside the usual price multiples. It's all about gradually expanding your knowledge and analytical toolkit.

EV/EBITDA

This is by far the most popular and widely used EV multiple.

EBITDA (earnings before interest, tax, depreciation and amortisation) is seen as a proxy for a company's pre-interest, pre-tax gross operating cash flow. It is favoured by some analysts and investors over measures such as the PE ratio because:

• EVs are better than PEs for comparing companies with different amounts of debt and cash. (This argument applies for all EV multiples). EBITDA is a pre-interest figure - unlike EPS - so looks at a number that can be claimed in part by a company's lenders and shareholders.
• Different companies have different depreciation, amortisation and tax - all of which distort EPS numbers. EBITDA gets rid of these distortions.
• Because of the deductions, EPS will be a negative number more often than EBITDA. EV/EBITDA therefore gives some way of valuing a loss-making company and comparing it with others.

Detractors of EV/EBITDA (including me) would make the following points:

• EBITDA is not a reliable measure of a company's operating cash flow. This is especially true for a fast-growing company which requires lots of working capital cash outflows. EBITDA will also not take into account companies making large top up pension deficit payments.
• EBITDA does not take into account the amount of money needed to replace a company's assets. This is especially true for capital intensive sectors such as food retail, pubs, manufacturing and mining where assets need to be replaced (replacement capital expenditure or capex) in order to maintain sales and profits.
• EBITDA also ignores differences in accounting policies such as revenue recognition and the the capitalisation of costs. For example, software companies can choose either to fully expense or to capitalise and amortise development costs. A company capitalising and amortising development costs would have a higher EBITDA than one which fully expensed them against revenues even if they had spent the same amount of cash.

So unless a company has no replacement capex, no tax bill, no pension deficit or no working capital requirements. EBITDA is not a good proxy for cash flow that can be paid to investors which makes EV/EBITDA a poor valuation method in my view.

But this is how it might be interpreted for the UK food retailing sector:

Sainsbury's would be seen as the cheapest company on this measure trading on just 6.2 times its last annual EBITDA with Ocado the most expensive on 25.3 times.

6.2 times is a very low multiple and may be seen as a sign of a very cheap business or one that is facing a number of challenges. 25.3 is expensive and requires many years of strong profits growth to justify it.

EV/FCFf

Free cash flow for the firm (FCFf) measures the amount of surplus cash flow left over to pay lenders and shareholders after assets have been replaced, new assets have been invested to grow the business (capex) and tax has been paid.

Providing capex levels are not too low (considerably less than replacement needs or depreciation) and the tax expense is not too high or low then FCFf is a good number to value companies. Professional investors will often adjust the capex number for maintenance or "stay in business" capex to get a better feel for underlying free cash flow generation. SharePad deducts all capex when calculating FCFf.

EV/FCFf or 10 or less can be a sign of very cheap share. Morrisons looks interesting from this point of view. McColl's which looked relatively cheap to its peers on EV/EBIT looks less attractive on this measure.

Closer inspection of McColl's reveals that this is due to working capital cash outflows. An investor would need to reassure themselves that these outflows were temporary. The same approach applies to companies whose FCFf has been boosted by temporary inflows of working capital.

EV/Sales

Price to sales is commonly used to weigh up the value of loss-making companies or those with cyclically-depressed profits in a recession. It was a measure that was used extensively by technology analysts during the dot-com boom of the late 1990s.

As with all price-based multiples, a price to sales multiple ignores companies which are financed by significant amounts of debt. Some of the sales will be needed to pay interest on debts. EV/Sales gets round this problem.

When I worked in the City I occasionally used to come across analyst reports comparing the EV/Sales ratio with a company's profit margins. Broadly speaking, the argument was that there was a correlation between the two numbers - higher margins justified higher EV/Sales multiples and vice versa.

For example, an ex-colleague of mine used to argue that a company with a 10% EBIT margin should trade on a EV/Sales multiple of 1.0. The rough and ready rule was that you divided the EBIT margin by 10 to get the implied EV/Sales multiple. So if a company had an EBIT margin of 5% it should trade on an EV/Sales multiple of 0.5 times. If it was less than that the shares might be undervalued.

On that basis, supermarket shares are no bargains. Perhaps, Sainsbury's with an EV/Sales of 0.3 and a profit margin of 2.6% is worth considering.

I'm not a fan of sales-based valuations. Profits and cash flows are what matters when the valuation of a company is concerned.

As for the EV/Sales versus profit margin argument. I can see where it is coming from, but would say that profit margins are not the sole determinant of company valuation. Crucially, they ignore the amount of money that has been spent to produce the margins.

Earnings power value (EPV)/EV

EPV (Earnings Power Value) gives you an estimated value of a business - an EV - based on its current operating profits (EBIT) after tax continuing forever. By comparing this value with the current EV you can have a feel for how much a company's current valuation is explained by its current profits and how much is based on future growth in profits. This ratio is one of my favourite ways of using EVs - I've called it EPV yield in the table below.

For example, McColl's has an EPV yield of 95.8% which suggests that almost all of its current EPV is explained by its current trading profits. Sainsbury is similar. Your job as an investor is to try and work out whether that is reasonable. Ask yourself:

• Can these businesses growth their profits from their existing business?
• Can they invest in new assets at reasonable ROCE (more than 10%)?

If the answer is yes, then perhaps the shares are undervalued.

Tesco and Ocado are the outliers here. More than 80% of their current EPV is explained by future profit growth. Again, ask yourself whether that is a reasonable expectation.