In the price to earnings conundrum video we encountered a situation where two different entrepreneurs bought an identical asset, in this case it was a pizza parlor or a pizzeria, but they each financed it in a different way. This guy was a little bit more conservative. He paid for it outright. The entire asset was his equity. He had no debt. While this guy, he borrowed some money and he even had some non-operating assets. So he levered up. For every $1 he put in he borrowed$10 from the bank in order to buy more assets that he actually brought to the table. And we saw when you did their financial statements-- their revenue, cost of goods-- everything up to the operating profit line was the same. And that makes sense because, if you remember the first introduction to income statement video, operating profit is really indicative of what the operating assets are generating. So in this case it's what this purple area right here is generating. You could also consider that the enterprise. What the enterprise is generating. And everything below the operating line, everything below the operating profit line, is either coming from non-operating assets, that would the case of non-operating income. And the entrepreneur on the right had some of that. He had some of this non-operating income, $2,000 per year in that case. While this guy didn't have any. And then you have expenses associated with interest. Right? In this case this entrepreneur had 5% of$100,000, so $5,000 a year. And then when you have these differences in capital structure it changes what your net income is. And they have slightly different net income numbers. But what we saw is when we applied the same price to earnings ratio, and they had the same share counts-- I didn't change too many variables here I just really changed how they paid for the asset. But when you apply the same price to earnings ratio to both earning streams, to both companies, you got something that was reasonably unintuitive. And there's no trick here really. Because it's not crazy to assign the same price to earnings ratio. And if you try it out, if you grow this guy's revenue a little bit, if you actually grow both of their revenues by the same amount or both of their gross profits by the same amount or if you grow both of their operating profits by the same amount, you're actually going to see that this guy's earnings per share is growing faster. So given that someone might say, oh, because of the leverage maybe I'm willing to pay even a higher multiple. So it's not crazy to pay the same multiple for both of these guys. But we saw at the end of the last video, when you apply, let's say, a 10 multiple, or really any multiple to both of these earning streams, you get a situation that at first doesn't look crazy. OK, the market cap of this guy is$210,000 if you apply a 10 multiple to their earnings stream, while the market cap of this guy is $189,000 if you apply a 10 multiple to their earning stream. Right? 10 times 18.9 thousand is 189,000. 10 times 21 thousand is 210,000. But what was the conundrum, what really got us thinking, was how can this whole equity stream right here, or this equity, or this earnings stream be, worth 210 and this one be worth 189 when this guy only put$10,000 in initially and this guy put $100,000? He put in 10 times as much. And so when you're paying$210,000 for this asset, for this equity, you are essentially saying that this asset is worth $210,000. But if you're saying that this equity is worth$189,000, right, that's what the market cap is. It's the value of the equity. Then you're implicitly saying that this asset, that all of these assets are worth the value of this market capitalization plus this debt, right? So that's $289,000. And then if you wanted the value of this operating asset you would subtract out this much right here, the cash. So you got something like$279,000. So when you apply the same price to earnings to to these similar businesses you've actually got a situation where you're overpaying for this asset relative to this one, even though they're identical. So that left us with a question: what do we do? What can we use other than a price to earnings ratio? And that's what this video is for. So the short answer is, one, you do have to use something different. Price to earnings ratio is a good a quick way of comparing two companies relative to their growth or relative to an industry. But it does lose a lot of information relative to how the companies are capitalized. You saw in the last video that how you're capitalized, and when I say capitalized I mean how do you pay for your assets. If you have a lot of debt versus a lot of equity, what actually happens on the earnings line is very, very different. And so you lose all of that information. And so if you want to capture that information, when you look at the price of a stock you have to figure out what you're actually paying for the enterprise of the company, the enterprise value of the company. So when I talk about the enterprise, or the enterprise value, I'm talking about the operating assets. It gets a little bit more complicated if you're talking about a financial company like a bank or an insurance company. But if we're talking about a widget factory, the enterprise is essentially the assets. The enterprise value is the asset value of the assets that allow the company to do business. So whatever factories-- well, in this case it's a pizzeria, so the ovens, the building, the places, where people actually eat their food, and even the cash that's necessary to operate the business. The enterprise value shouldn't incorporate the cash that's surplus, that's not necessary to operate the business. So that begs the question, how do you calculate the enterprise value? So you could go backwards and you say, OK, for a given price how much am I paying for an enterprise value? So let's say that this stock-- let's say that Company A or this one, let's say the stock right now is trading at $20. So this is the current price that you could buy it at. So it's the asking price in the market is at$20. While this one is at, let's say it's at $10. It's at$10. So at first glance you might just do a quick price to earnings ratio. And you'll say, OK, for $20 I'm getting$2.10 earnings per year, assuming it's not growing or something. So my price to earnings is approximately, I don't know have my calculator in front of me, but $20 divided by$2.10 is going to be 9 point something, something. Right? While this guy, for $10, I am getting$1.89 of earnings per year. So what's 100 divided by 18? It's 5 or 6 times. It's going to be 5 point something. 6 times 18 is 60 plus -- Yeah it's going to be 5 point something, something. So when you superficially just look at this you're going to say, wow, this is a cheaper price to earnings ratio, maybe I should buy that. But what we saw in the last video is that price to earnings isn't a good relative valuation metric when two different companies are capitalized very differently. So what you want to do is instead back out what these prices imply about the enterprise value. So what does $20 imply about the enterprise value and what does$10 imply. And how do you do that? Well first you say what is the market cap? Market cap. So you take the price times the number of shares. If you remember, we had 10,000 shares. So in this case $20 times 10,000 shares implies a$200,000 market cap. In this case we have $10 times 10,000 shares so it implies a$100,000 market cap. Now remember, the market cap is just what's left over. So let me redraw those two diagrams because I feel like I'm-- So for this entrepreneur you have the assets and there's no debt. So the assets are kind of completely represented by the equity. So if the market cap is $200,000 you're essentially saying that these assets, these operating assets, are worth$200,000. So in this case, at a price of $20, we know that the enterprise value, the market enterprise value, so what the market is saying the enterprise is worth, the operating assets are worth, is$200,000. Now, in this case, remember the market is saying that the equity is worth $100,000. Let me draw that. The market is saying that the equity is worth$100,000. But of course this company has a lot of debt. It has another $100,000 of debt. Actually let me draw this a little bit different. All right. So in this situation the market is saying that its market cap is$100,000. So just to be proportional let me draw it like that. Not really use that one. So $100,000, this is the equity or the market capitalization or the market value of the equity. That's what the market cap is. So that's just the price times the number of shares. And then it has debt. If I remember correctly it has$100,000 in debt. We take $100,000 in debt.$100,000. And so what is it saying about the assets? So the equity plus the debt, or the liabilities, is $200,000. So it's saying all of the assets are worth$200,000. This is all of the assets, $200,000. But what we need to do, we want to figure out the value of the enterprise. Not just all of the assets. So if we remember there was some of the assets that were actually operational and some were non-operational. So we had$10,000 of cash right there. So we have $10,000 of cash. So when this stock is trading at$10 it implies a market capitalization of $100,000. It implies that the liabilities plus equity is$200,000. So all of the assets are $200,000. But if we were to subtract out the cash or the non-operating assets, what's not necessary to operate the business, we get$190,000 of enterprise value. So in this case we're saying that the enterprise value is $190,000. So in this case, when you look at the price to earnings you're like, wow, this is half as expensive as that. This is great deal, let me buy it. And I just happened to make up the numbers so even when I did the enterprise value it's only 5% cheaper. Here it looks 50% cheaper. Here it looks 5% cheaper. And so it might be a little unintuitive. To figure out the enterprise value you take, and this will be the formula you see in a lot of books. Enterprise value is equal to market cap plus debt minus cash. And you might be like, when I'm trying to value something why should I add debt back? Debt is a negative thing. Shouldn't debt make my enterprise worth less? And why am I subtracting cash? Because cash is a positive thing, shouldn't that make my enterprise value more? And the reason why, first, you subtract cash is, and it really should be just cash that is not associated with the enterprise. And you'll see a lot of people do it in different ways. Some people subtract out all cash with the argument that the company doesn't need to use any of it. But the real idea behind it is to kind of capture the assets that are actually generating the profits of the enterprise. And the profits of the enterprise are the operating profits. And the reason why you add debt is, think about it this way. If you wanted to buy out this company. Let's say from this company you wanted to buy his assets at the market price. How would you do it? You would have to pay, what? You would have to maybe get$200,000. If you got $200,000 you could buy these guys off. You could pay them$100,000 and own that. And then you could buy the bank out and pay them $100,000. So if you paid$200,000, you would own all of this. Right? This would all be your equity. And then you would get $10,000 back if you know if you wanted to take this cash, right? So you would have essentially paid$200,000 which is the market cap plus the debt. That's what you would have to do to buy out both of those stakeholders in the company. And then you would get back the cash. So you would have to pay net $190,000 to own this enterprise. And hopefully that makes a little bit more sense as why the enterprise value is actually described this way. Now the one thing you might say, OK, Sal, you figured out how to calculate enterprise value from a share price. But what if I want to go the other way around. How do I figure out what a company's enterprise value should be and then figure out what its share price should be? Well one metric, and there's two metrics. The most common metric that's used is EBITDA. EBITDA. I won't cover that now because it's a new term for you, but it means earnings before interest, taxes, depreciation, and amortization. And people look at something called an enterprise value to EBITDA ratio. And I'll do that in the next video. But what I like to do is just think about, OK, what are the real earnings from the enterprise? Well, that's the operating profit. That's the operating profit, right? And then you could apply a multiple to that based on what other companies are trading at or how fast it's growing. Let's say in this case we're saying they're both generating$30,000 in operating profit per year. Let's say that I want to apply a 5 multiple to its operating profits. So let's say I want to say that EV to operating profit, which I frankly think is a better metric than EV to EBITDA-- and I'll cover EBITDA in a future video-- let's say that I think for this industry it should be 5. Let me say it should be 6. 6 times is a good multiple. So in both those cases the operating profit was $30,000. So that means that EV should be$30,000 times 6, which is equal to $180,000. Now for the first guy if the EV is$180,000, if I'm saying that this thing right here, the market value, should be $180,000, then I'm implying that the equity should be worth$180,000. And there are 10,000 shares. So essentially I would take that EV and I would say, well, all of that's equity, there's no cash there, there's no debt, so all of this is equity. So I would divide that by the shares. I would say that the market cap for the first guy should be $180,000. So the per-share price, the price I'd be willing to pay, is$18. Because it had 10,000 shares. $18. Now let's take the second guy's situation. We both agree in both situations their enterprise value should be$180,000. But in this guy's case, what are the assets? The assets are the enterprise, $180,000 plus$10,000. Plus $10,000, right? This whole left-hand side is$190,000. And then if you wanted to subtract out, figure out the market cap, you would take this whole thing and then subtract out the debt to get the market cap. Right? And then you would be left with this piece right here. That right there, right? You were just figuring out this whole distance, subtracting out this distance. So essentially you would say that the market cap is equal to the enterprise value plus the cash minus the debt. And it's good to draw those balance sheets if you ever get confused. Minus the debt. So the market cap is equal to $190,000 minus$100,000 is equal to $90,000. And so if you divide that by 10,000 shares you'd say that I'm willing to pay$9 per share. So if you believe that the enterprise value of these pizzerias are identical and that they're both worth $180,000, you should be willing to pay$18 for Company A. And if you're completely equivalent to it, you should pay \$9 for Company B. And now if you're a little bit more aggressive you might like the leverage, you might like how Company B is growing, et cetera. Maybe you would like to pay a premium for that leverage or maybe you wouldn't, because it also increases your risk. Because you get leverage on the upside or on the downside. But anyways I wanted to introduce you to value. On the next video I'll introduce you to EBITDA.