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### Course: Finance and capital markets>Unit 6

Lesson 4: Corporate metrics and valuation

# Enterprise value

Solving the P/E conundrum by looking at a different valuation metric (enterprise value). Created by Sal Khan.

## Want to join the conversation?

• How do you determine a "good" multiple?
• To determine a good multiple for a sector, look at the median multiple of similar companies within the sector. What you will find is that higher profit margins and growth rates tend to increase a sector's median multiple vis-a-vis lower profit margin and lower growth sectors. The nature of the revenue will also have a large effect. For example, a cloud-based software company will generally have a higher multiple than a retail company because its "recurring" revenue is predictable. Multiples can also move cyclically. A good example is clean tech companies which were getting better multiples than they are today (I believe this is primarily related to investors' risk tolerances, but there are certainly other factors). If you are really interested in valuation, a good resource is Professor Aswath Damodaran of NYU. He has a website and several book dedicated to valuation topics. Hope that helps.
• I did not understand "the multiple" Why did Sal use a multiple of six? Does that have anything to do with the growth of the company?
• the multiple doesn't have to do with the growth, it is an artifact of how companies or valued, or how we determine how much companies are worth. if a company is generating \$10,000 in profits this year, we would apply a certain multiple to that profit to determine how much we would pay for the company or how much we would buy the company for. i think sal just uses a very arbitrary multiple here
• What does Sal mean when he applies a multiple. What is a multiple?
• Yes, a multiple is a "rule of thumb". Here's how you would "apply" the multiple: If the best multiple for the sector is price/earnings (P/E) and investors look at the most recent year's numbers, the way to estimate how much the company is to multiply the company's earnings (a.k.a. profit) by the P/E multiple. If a company had \$1 million in profit and the P/E multiple for similar companies is ~15x, the estimated worth of the company would be \$15 million.
• However, the "Enterprise Valuing Approach" still has not solved the problem! We are still paying for Equity in company B what equals half of what we would pay for Equity in company A (i.e. \$9 for B and only \$18 for A)though Equity in company A in reality equals 10 times Equity in company B. So, how this approach is supposed to solve the misleading approached described in the previous video?
• I have this same question/problem. I think part of our problem stems from focusing too heavily on book value and not the market price or "going concern" value. The value of a companies assets are not simply the book value of those assets. The book value of the equity in company B is 1/10th of that of company A as you said but we are trying to value the company as a going concern and not simply at liquidation value.
I don't know if this is correct; I'm still trying to work through it myself...
• Hi Sal, I always wonder why people calculate Enterprise Value using Market Cap instead of Equity's book value, since the actual assets being utilized by a firm to earn an operating profit are contributed by initial book value of equity instead of what the market perceives the assets are worth.
However, some people also argue that Market Cap is used so that the future benefits of assets that will benefit the company can be measured more reliably, if so, should not the the assets utilized that are contributed by the creditors also be revalued to market value?
This is why this formula confuses me a lot, as the equity is valued at market price while the debt is valued with historical price.....?
The second reason that I do not agree with the way how people use Market Cap is because, the Market Cap does take volatile movement led by irrational nature of market price into account(although average price may be used, Warren Buffett and other typical value investors still believes that the market does not work as efficient as we thought, which price does not always equal value).
Excuse me, if my explanation does not make sense, as I am a beginner in investment field, so if some of my concepts are wrong please correct me
If possible can Sal or someone who are experts in this field help me out?
• A lot of calculations come down to ease of use. Market Cap is used because it is so readily available and because book value of equity doesn't necessarily give an accurate picture. You want the most accurate estimate of what a company is currently worth and the current value of their assets can differ considerably from their initial book value. Also, book values are often just estimates by management (especially when it comes to intangible assets), whereas market cap is an estimate based on the combined opinion of every market participant.

No one is saying you HAVE to value debt at historical prices, but often times it's a lot easier. Corporate bonds trade almost exclusively through dealers, not on exchanges like stocks. They are far less liquid and therefore it is often difficult to find accurate market prices for every single debt instrument a company has issued. A large company can have hundreds of different debt issuance's all at different prices. If more accurate numbers are available, then you can make an adjustment to the equation to reflect that. Adjustments can be made to market cap as well if you feel more accurate information is available. It's often more of an art than a science.
• In what way is the EV different from the (operational) assets of the company? At , Sal circles the operation's assets as if they are the EV, but later on the EV is worth much more in both restaurants.

Also, Sal says at that the conundrum is how could the small equity on the right be valued higher than the large equity on the left. To me, it looks like people are looking forward to the large growth that comes from paying off the debt, which is why they're willing to pay the same P/E ratio. What's my mistake?
• The enterprise value is the value to buy the entire company. If you buy an entire company you get all the assets and are responsible for all the liabilities. So, you start with the market cap (the value of all the equity). Then you add debt and preferred shares because if you bought the company you'd also be responsible for paying these liabilities. You subtract the cash because if you bought a company with cash and received the cash the company already had, it would cancel each other out.

Operating assets are different because they are just the assets that are used to generate profits during normal business operations. They don't factor in any of the debt you'd be responsible for paying if you took over the entire company.

In the P/E ratio (price / earnings per share) the denominator is calculated using net income, which is the bottom line on the income statement after taxes and interest payments. If a company has a lot of debt, the interest on their debt is an expense on the income statement which lowers net income and therefore lowers earnings per share. If the denominator in the P/E ratio falls, the P/E ratio increases. So, when two company's are identical in every way, except one has some debt, the company with debt will have a higher P/E ratio. Therefore it is also possible for a smaller company that has some debt to have the same P/E ratio as a larger company with no debt. This is just an accounting metric and has nothing to do with investor expectations. But it goes to show why it is difficult to use P/E ratios to compare two companies with different levels of debt and equity.
• I don't understand. If the P/E was "bad" because it rated two completely different companies (one completely unleveraged, and the other completely leveraged) the same (actually - Sal just decided it's 10 for both), how come the EV is better, when it gives an allmost identical rating to the same companies (200 vs. 190)?
• EV and P/E value different things. P/E values the equity. EV values the whole company.
• I need some help understanding leverage at the beginning of this video and in the last. At point
I understand that in relation to the equity of the company the business is leverage; the value of the assets for company B is 10x the equity whereas company A has no leverage. I understand that the return on equity for the second company will be much larger because of this leverage.
What I'm unclear with is how a given % growth in the top line of company B translates to a greater % growth in the bottom line than it does in company A.

Ex : Op Income grows by 15% for both companies. This translates to a 15% growth in profit for company A and a 16.7% growth for company B. Is this because of the advantage of tax deductibility of the interest expense? I feel like I'm missing something obvious.
Thanks
• It's because the interest that company B pays does not increase as its top line increases. A higher proportion of B's total costs are fixed than is true for A. More fixed cost means higher percentage growth as top line grows.

The tax deductibility reduces the cost of the debt but it does not change from year to year so it has nothing to do with the growth rate.