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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. And then let's say they have some excess cash. Cash that's not necessary to actually operate the business. I'll draw 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 value of the enterprise out of the market value of the equity or the 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. Here is the debt. 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. When I write the enterprise here, this is the value of the business itself. So it's kind of the operational assets net of the operational liabilities. It's literally-- if you had to go out in the past two 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 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 accountants say that the book value of our equity is worth. But the market value, figure it out from what the market's willing to pay for a share. So the market value of equity or the 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 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 plus, let's just say the market cap. Because 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, because it's the same thing. Market capitalization is the market's 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 we just subtract cash from both sides, and we get enterprise value is equal to market cap plus debt minus cash. We're just taking cash onto the right-hand side of this equation. 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 1 million shares. And let's say that the company has $50 million of debt. And let's say it has $5 million 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. And once again, I said this in the last video, it's 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 from the stakeholders and be debt free, they would have to pay these people the total amount of debt, and they'd 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 get a refund of the cash. This would be extra stuff that they would be buying that they could get money back for. So you have to pay the equity holders, you have to pay the debt holders, and then you get a refund of the cash. And so the enterprise value's 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 compared that to earnings. The price to earnings ratio. You were doing this on a per share. This is price per share divided by earnings per share. This ratio's equivalent to market cap divided by the actual 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. P/E is actually price per share divided by earnings per share. And that was one way to look at it. You could compare two companies. And 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 cap to 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 look at essentially 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 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 100. You have your cost of goods sold. Cost of goods sold could be, let's say it's minus 50. And I'll show you another convention. One of the commenters suggested that I do this convention. Which is actually the most typical convention for a lot of accountants and financial analysts. Instead of writing a negative, they'll write it in parentheses. That means negative. Minus 50. And then the gross profit would be 50. And then, actually I want 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 appreciation and amortization is actually occurring at the corporate level. So let's say that there is some SG&A. But this is without the depreciation and amortization. So let's say that this is an expense of 10. Let's say there's some depreciation and amortization as well. D&A. In the last couple of videos I kind of grouped. And that tends to be the case. On a lot of income statements they won't separate 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 5. Maybe these are in thousands. And then you're left with the 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-- you have the non-operating income and interest and all that. Let me just do that. Interest. Let's say that that is also 5,000, if that's what we care about. And then you have pre-tax. I didn't put the non-operating income. 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. Let's say it's 1/3. It's 10,000 of taxes. And then you have earnings. 30 minus 10 is 20,000. So I suggested, what part of this income statement is 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 debt. Because the more interest you have, the more you can deduct it. And so all of this down here is dependent on your capital structure. So if you wanted to look just what the enterprise value is generating, it's generating the operating profit. 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 said a lot. I'd argue that you could look at EV to operating profit as a good metric. Which in a lot of cases is the inverse of the 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 EBITDA. 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 a company. And hopefully talk reasonably intelligently about it. So the first question, to talk reasonably intelligently about anything is, what is EBITDA? So EBITDA is Earnings Before Interest, Taxes, Depreciation and Amortization. So 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. Actually, let's compare that to something we covered before. So you have EBITDA. And you have EBIT. EBIT is Earnings Before Interest and Taxes. So EBIT 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 profit unrelated to the operations of the business, it'd be included in EBIT. It wouldn't be an operating profit. But they're usually pretty close if we're talking about, let's say, a non-financial type of business. So this is EBIT. And if you want to get EBITDA, you just add back the depreciation and amortization. So EBITDA would be here. So the EBIT is 35,000. If you add that back, it would be 40,000. So the EBITDA in this case is 40. And if my units are in thousands, it's 40,000. Now the question is, why do people care about EBITDA? Why is EBITDA used instead of operating profit? And the logic 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 and amortization. Maybe this is, I bought a $100 or $100,000 object 10 years ago. And every year I depreciate 1/20 of it. But the cash went out the door 20 years ago. And so this depreciation and amortization in this period, it isn't necessarily cash out of the door. In fact, it isn't cash out the door. 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. So when you figure out EBITDA, 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? 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 look at EV to EBITDA, you're saying for every dollar of raw cash that this business spits out. And let's say I were not to reinvest in the business or buy new equipment. If it's 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 regular time limit, is that for a very, stable, simple, non-declining non-growing business, five times EBITDA is considered a good valuation. But what matters more is what other companies in that industry are trading at. So all of these ratios are better as relative valuation metrics. In the future I'll show you how to do maybe a discounted cash flow or a discounted free cash flow type of analysis. Or a dividend discount model or something, so you can kind of figure out an absolute value. But when you're looking in public markets, when you're picking to decide something, you're also implicitly picking not to buy other things. When 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.