Ever since I wrote on the valuation method using price-earnings-growth ratio, I continue to hold the firm belief that value investing is the way of long term investing and it can be easily understood, which brought me to writing this article as I explore deeper. I will be introducing the measure of a company’s value using enterprise value (EV) along with its uses as part of the value investing criteria.

Mergers and acquisitions are common events in today’s financial market. A general question is often inquired: what is the true value of the takeover company? Judging the worth of a company based solely on its market capitalization, which only includes common equity, is insufficient. EV or total enterprise value (TEV) provides a more accurate estimate of a firm’s value by taking into account its total debt, which can be interpreted as when the acquirer buys the target company, the former will also be buying all of the latter’s debt. The formula of EV is simply:

EV = Market Cap + Total Debt – Cash and Cash Equivalents

In words, EV is what it would cost the acquirer to purchase the target company’s common shares, preferred shares, and its long term and short term debt, while pocketing its cash reserves. Another calculation of EV includes the addition of minority interest, the portion of a subsidiary’s net income that the parent company is not entitled to. For simplicity and due to the insignificance of minority interests in the following example, it will not be included in the calculation of EV presented in this article.

Uses Of EV

Examining some of its uses, EV can be measured with EBITDA and sales to provide a comparative view in the evaluation of undervalued stocks. In addition, EV can be used to determine if the acquisition price proposed by the acquirer is appropriate. Using the valuation ratios created by EV, one would be able to determine if the share price of a company is fairly priced compared to its peers. Let’s make a comparison of the 3 local telecommunication companies based on the above discussions.

It appears that SingTel is priced higher on a per share basis as compared to its smaller peers StarHub and M1, which are cheaper bargains from the result revealed by the ratios. The enterprise value multiple (TEV/ EBITDA) of 7.82 derived from M1 could be depicted from a potential acquirer’s point of view that it would take approximately 7.82 years worth of M1’s earnings to pay off its acquisition cost (assuming TEV).

The TEV/ Sales ratio analysis tells us that StarHub is the cheapest among all with the lowest ratio at 2.31 times its revenue over the past 12 months. However, judging from the TEV/ EBITDA metric, M1 is a better value buy than StarHub. This means that M1 is able to generate a higher EBITDA margin than StarHub, which can be observed from the above data (using EBITDA/ Sales), and that M1 may be more efficient in managing its operating expenditure.

Good Valuation Measure But Not Foolproof

The EV multiple indeed provides a clearer picture than only looking at market capitalization and is able to compare companies with different capital structure. However, the theoretical measure is not able to fully reflect a company’s true value. Qualitative factors such as good management team, competitive brand advantage, strong corporate governance, are important criteria to consider when performing stock analysis. From the discussion earlier, SingTel appears overpriced but it enjoys the status of a market leader. SingTel is currently the largest mobile operator in Singapore, capturing more than 40% of the local mobile phone market share, and maintains a diversified business portfolio with overseas operations and investments.

Bottom line, I suggest that the enterprise value multiple should be included in a stock analysis as it serves as a good complement to other valuation ratios.