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..