How to use EV multiple ratios to evaluate stocks?

In the investment world, every investor wants to bargain against the true or intrinsic value of the company. The one of the valuation methods that is most common in the investor community is relative valuation models. Read on to know more...

The key reason for the popularity of the relative valuation method is that similar assets should sell at similar prices, and relative valuation is typically implemented using price multiples (ratios of stock price to a fundamental such as earning per share etc) or enterprise multiples.

In this article, we would focus on enterprise multiple valuations.

What is Enterprise Value (EV)?

EV= Market value of equity + Market value of debt – Cash and cash investments

The total market value of Equity and debt net of cash and short-term investments this metric is useful in the process when one company is looking for acquisition of other company. In short, we can say that enterprise value is market value of operating asset of the company. The enterprise value is useful to compare the companies with different capital structures. We can use this enterprise value as a multiple valuation metric to find how the company is valued in respect to other firms operating in the same industry.

EV/EBITDA simply tells us how the company is poised to generate operating profit with respect to its operating asset. The key importance of use EV multiple is that we can use this valuation metric even though company’s capital structure is not constant because while calculating EV we do add value of debt and we use EBITDA which does not include interest expense. Generally, this ratio is mostly used in the capital-intensive industry where companies mostly have debt on their balance sheet. This ratio can also be used when the company’s net profit is negative.

The other relative valuation metric which is widely used in the valuation process is EV/Sales. This ratio is more reliable than P/S since while calculating EV we do consider the amount of debt a company must repay at some point. This is useful when company’s operating profit is negative.

With respect to both EV/EBITDA and EV/Sales, the lower the ratio the better it is, because lower multiple valuations imply that the company is more attractive than its close peers.