The recent spate of takeover activity is a useful reminder to consider a business and its financial position in the round when looking at valuation.
The most widely-used marker of a stock's value is the price to earnings ratio, or PE for short. It is calculated by dividing earnings per share (either historic or forecast) by the current share price.
However, this takes little account of a company’s balance sheet. Firms saddled with lots of debt will often trade on depressed PE multiples because of the implied threat of financial stress on a business burdened with hefty borrowings.
Conversely, companies with lots of net cash on their books can look expensive in PE terms. This is partly because in the current low interest rate environment interest accrued on those liquid assets is negligible and the contributions to earnings and return on capital tiny.
TAKING INTO ACCOUNT DEBT
Shares recently explained this in an in-depth feature, and how investors can adjust for debt in their own PE calculations.
A more traditional way to account for net cash or debt in valuation is by using the enterprise value (EV).
EV is also particularly good at ensuring the investor performs a thorough analysis of a firm’s balance sheet and especially its liabilities.
It is also relevant to dealmaking as the EV represents the total cost of acquiring a firm and 100% of its cash flow - not just its market cap but also any debts it may have, as any trade buyer would inherit these in the case of an acquisition.
EV multiples are therefore frequently quoted in merger and acquisition deals and used as benchmarks of the valuations applied to a given group of stocks or industry.
Examples of relevant multiples include EV/sales and EV/earnings before interest taxes depreciation and amortisation (EBITDA).
