Enterprise Value

Enterprise value is built by walking up the capital structure. Start with the market value of common equity, then add every other claim that has been funded by outside capital and that has a call on operating cash flow: interest-bearing debt (short and long term), preferred shares, and the non-controlling interests in consolidated subsidiaries whose full earnings appear in the income statement. Finally subtract cash and marketable securities, because an acquirer taking control of the business gains immediate access to that cash and can use it to retire part of the purchase price.

The logic is that of an acquisition. Buying the shares alone does not deliver an unencumbered business; the debt travels with it and must be repaid or refinanced. Conversely, surplus cash is not part of the operating engine. What remains after these adjustments is the value the market places on the productive assets, whoever happens to have financed them.

An enterprise value multiple is only coherent if the denominator belongs to all capital providers. EBITDA, EBIT, unlevered free cash flow, sales and invested capital are all struck before interest expense, so they are legitimate partners for EV. Net income, earnings per share and book value of equity are residual, post-interest measures and belong with price-based multiples such as P/E or P/B. Dividing enterprise value by net income mixes a whole-firm numerator with an equity-only denominator and produces a figure that rises mechanically with leverage.

This discipline is why EV/EBITDA dominates comparisons across firms with different debt loads, across borders where tax and interest regimes diverge, and in capital-intensive sectors where depreciation policies differ. It is also why loss-making or highly leveraged companies, whose P/E is meaningless or negative, can still be screened on an EV basis.

Market capitalisation uses the current share price multiplied by shares outstanding, ideally adjusted for dilutive instruments; the remaining components come from the most recent balance sheet. Debt is usually taken at book value as a practical proxy, though for distressed issuers or bonds trading far from par the market value is more faithful. Practitioners frequently capitalise obligations that behave like debt, notably lease liabilities and material unfunded pension deficits, and remove non-operating assets such as investments in associates or excess real estate whose earnings never appear in EBITDA.

Judgement is unavoidable on cash. Some operating cash is required to run the business, so subtracting the entire balance can overstate the deduction. Whatever convention is adopted, it must be applied identically to every company in the peer set, otherwise the resulting multiples are not comparable.

At Level I the expectation is procedural and interpretive. You should be able to construct enterprise value from a set of financial statement and market data, compute EV/EBITDA and EV/sales, and identify which denominators are admissible. You should be able to explain why an EV multiple neutralises capital structure differences that distort price multiples, and why differences in EV/EBITDA across peers may reflect growth, margins, reinvestment needs or risk rather than genuine mispricing.

You should also read the net debt position for what it says. A company whose cash exceeds its borrowings has negative net debt, which compresses enterprise value relative to equity value and lowers every EV multiple. Recognising that effect, rather than concluding the shares are cheap, is the analytical step examiners test.