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Current time:0:00Total duration:14:07

Video transcript

in the last couple of videos we saw that looking just purely at market capitalization can be a little bit misleading when you look at companies that have a good bit of leverage or companies that have a good bit of debt for example if that's the assets of the company and let's say that they have this much debt and this is their equity this is their equity and then let's say they have some excess cash cast that's not necessary to actually operate the business I'll throw that up here so this is excess cash some cash is necessary and oftentimes people don't make the distinction and they'll just view this as all the cash but we really want to separate the vet the value of the enterprise out of the market value of the equity or the add value of the debt so let me just write all this down so this right here this is the value of the business the enterprise value enterprise value right here is the debt right there's the debt and this is the equity and this is a little bit of a slight I would say technicality and you don't have to worry about this if it confuses you at all is when I write the enterprise value here this is the value of the business itself so it's kind of the the operational assets net of the operation liabilities it's literally if you had to go out and in the past few examples and buy the pizzeria how much net would you have to pay for that pizzeria and that's what we're trying to figure out for one right here when we're talking about the enterprise value and we saw in the last couple of videos how you calculate it but it never hurts to review it this is actually one of those less intuitive calculations the first few times you see it so it doesn't hurt to do it again so the first thing to figure out is how do you figure out the market value of the equity the book value of the equity is very easy you could go into a company's balance sheet and they'll write down a number they'll say this is what our our accountants say that our are the book value of our equity is worth but the market value figure it out from what the markets willing to pay for share so if you the market value of equity or the market cap market cap is equal to price per share times the number of shares and that's the market value of this equity and you can see just even from this diagram that the enterprise value the enterprise value plus the non operating cash or investments or liquid investments whatever you want to call them enterprise value plus the cash is equal to the debt debt plus let's just say the market cap right because we want to know that what we want to know when we look at a price we want to be able to figure out what is the market saying the enterprise value of the company is what is the market value of the enterprise so debt plus instead of equity I'll write market capitalization it's the same thing market capitalization is the markets value of the equity plus market cap so we know market cap we can look up the debt on a company's balance sheet we can look up the cash so then we get we just subtract cash from both sides and we get enterprise value is equal to enterprise value is equal to output market cap first market cap market cap plus debt minus cash right we're just taking cash onto the right-hand side of this equation minus cash so for example if I have a stock that is trading at let's say the price is $10 and let's say that there are shares let's say there are 1 million shares and let's say that the company has the company has 50 million of debt and let's say it has 5 million of cash of excess cash what's its enterprise value well you first figure out its market cap its market cap is $10 per share times a million shares so that's 10 million shares that's the market cap you add the debt so plus 50 million dollars and once again I said this in the last fits very unintuitive when you figure out the value of the enterprise to add the debt and the intuition is that if someone were to want to buy this company out of from the stake holders and be debt free they would have to pay these people the total amount of debt and they would have to pay these people the total amount of the market value so they'd have to pay the debt plus the equity and they'd get a refund of the cash right this would be kind of extra stuff that they would be buying that they could get money back for so you have to pay the equity holders you'd have to pay the debt holders and then you get a refund of the cash and so the enterprise value is what 60 million minus 5 that's 55 million fair enough this is all just review of the enterprise value video but the question is now that you've figured out enterprise value how do you figure out if that's a fair enterprise value when you looked at market capitalization you compare that to earnings right price to earnings the price to earnings ratio you're doing this on a per share this is price per share divided by earnings per share right this is this ratio is equivalent to market cap divided by the actual net income of the company net income of the company where if you just multiply the numerator and the denominator by the number of shares you get market cap and net income this is EPS pde is actually price per share divided by earnings per share and that was one way to look at it you and you could compare to companies that we saw it breaks down if they have different types of capital structure so what do you compare enterprise value to here we did market vector net income enterprise value should be compared to what now I made an argument in the last video that well if we're looking at the enterprise we should we should look at essentially at the earnings that are popping out of the enterprise we should look at the earnings that are coming out of this asset right here and we're on the very first video on the income statement I implied that let's do a balance sheet you have your revenue your revenue could be a hundred you have your cost of goods sold cost of goods sold could be let's say it's a minus 50 and I'll show you another conventions one of the one of the commenter suggested that I do this convention which is actually the most typical convention for a lot of accountants and financial analyst instead of writing a negative they'll write in parentheses that means negative minus 50 and then the gross profit gross profit would be 50 and then actually I'm going to do something a little bit interesting let's say that this cost of goods sold it involves no depreciation or amortization and watch those videos if those words confuse you and all of the depreciation and amortization is actually occurring at the corporate level so let's say that there is some SGA SG&A but this is without the depreciation and amortization so this is so let's say that this is an expense of let's say this is an expense of 10 and let's say there's some depreciation and amortization as well d and a depreciation and amortization the last couple of videos that kind of group and that tends to be the case a lot of income statements they won't separate the out the depreciation and amortization and you'll actually have to look at the cash flow statement to figure out what this is and I'm going to do that in a future video but let's say that we actually do break it out sometimes that does happen and let's say that that's another that's another five maybe these are in thousands and then you're left with the operating profit operating profit in this case which is 50 minus 15 so it's 35 and then you have things below that you have interest and I'll do those just for if you have the non operating income and interest in all that let me just do that interest interest let's say that that is also a I don't know 5,000 if that's what we care about and then you have pre-tax I didn't put the non operating income that this let's say this cash isn't generating anything so pre-tax income is 30,000 if that's what we're dealing with it's getting a little messy so then you have taxes since 30 let's say it's one-third so it's 10,000 of taxes and then you have earnings earnings 30 minus 10 is 20,000 so I suggested what what part of this income statement is generated is dependant Perley on this piece right here dependent purely on this piece right here well all this stuff with interest that's dependent on the debt and essentially taxes is also dependent on the because the more interest you have the more you can deduct it and and so all of all of this down here is dependent on your capital structure right so if you wanted to look just what the enterprise value is generating is generating the operating profit it's generating the operating profit right there so I suggested that a pretty good ratio although this is very non-traditional it's not very not traditional but you don't hear it set a lot is I argue that you could look at Evita operating profit as a good metric evie to operating profit operating profit which in a lot of cases is the is the inverse of the return on return on assets as I defined it in the first video there's a lot of different return on asset definitions but it's essentially saying for every dollar of operating profit how much are you paying for the enterprise which i think is a pretty good metric now the more conventional metric that you'll see when you see people talk about enterprise values enterprise value to EBIT da and if you go and get a job as a research analyst at some firm this is going to be something that you're going to be expected to calculate for company and and hopefully talk reasonably intelligent about it so the first question to to talk recently be reasonably intelligent about anything is what is EBIT da so EBIT da is earnings before interest taxes depreciation and amortization so let's let's see what that would be here so it's earnings before interest taxes depreciation and amortization so it's before all of this stuff right actually let's compare that to something that we covered before so you have a bit da you have a bit da and you have a bit a bit is earnings before interest in taxes so E bit is earnings you add back taxes and interest you're at operating profit and I've gone over this in the past but the distinction between operating profit and EBIT is that EBIT might include some non operating income which I haven't put here but if this cash was generating some thing some profit unrelated to the operations of the business it would be included in EBIT it wouldn't be an operating profit but they're usually pretty close if we're talking about a let's say a non-financial type of business so this is a bit and then if you want to get a bit dodgy you just add back the depreciation and amortization so EBIT da would be here e bit da so you would add back the op de bit is thirty five thousand I guess if you add that back it would be forty thousand so the e bit on this case is forty and if these are my units or in thousands its forty thousand now the question is why do people care about eBay da why is e ba da used instead of operating profit and the logic is is that depreciation and amortization and we did this in the depreciation and amortization videos these are just spread out costs that necessarily aren't cash going out the door in this period we saw that this depreciation amortization maybe this is I bought a $100 or $100,000 object ten years ago and every year or let's say and every year I I appreciate one twentieth of it right but the cash went out the door twenty years ago and so this depreciation amortization in this period it isn't necessarily cash out of the door in fact it isn't cash under the door and we'll talk in future videos about how do you find out what the cash out the door is in a period so it's considered a non-cash expense non-cash so when you figure out a bit da when you add back taxes you add back interest and you add back depreciation and amortization what you're left with is essentially how much raw cash is the enterprise spitting out so it's raw cash is it spitting out and a lot of people care about this because this is an indication of one the company's ability to do things - to do things like pay its interest pay its taxes or invest in the business itself or another way to view it is if you paid if you take if you if you look at Evie the eBay da you're saying for every dollar of raw cash that this business spits out and let's say I would not reinvest in the business or or or buy new equipment if just raw dollars how much am I paying for the enterprise and a general rule of thumb and we'll do more on this in the future I think I'm already well over my my regular time limit is that for a very kind of stable simple non declining non growing business five times EBIT da is considered a good valuation but what matters more is what other companies in that industry are trading at so what all of these ratios they're they're better as relative valuation metrics and the future I'll show you how to do maybe a discounted cash flow or discounted free cash flow type of analysis or dividend discount model or something so you can kind of figure out an absolute value but it when you're looking at in public markets you're when you're picking to decide something you're also implicitly picking not to buy other things or you're choosing to sell something you're also implicitly choosing not to sell other things so relative value starts to matter a little bit more anyway hopefully you found that helpful