Relative valuation - EV-based measures and adjustments

Learning Outcomes

After completing this article, you will be able to explain the rationale and calculation of enterprise value (EV), use EV-based multiples for company valuation, and apply key adjustments when analysing and comparing companies for ACCA Financial Management. You will learn to critically assess the strengths and weaknesses of EV-based relative valuation techniques in line with exam requirements.

ACCA Financial Management (FM) Syllabus

For ACCA Financial Management (FM), you are required to understand EV-based valuation methods as part of relative business valuation techniques. In particular, you should be comfortable with:

• The concept, calculation, and interpretation of enterprise value (EV)
• The use and purpose of EV-based multiples (e.g., EV/EBITDA) for valuing businesses
• The necessity and process for making adjustments to EV, debt, and earnings to ensure consistency between comparator companies
• The strengths and limitations of relative valuation based on EV multiples
• The practical application of EV-based relative valuation in company analysis and acquisition

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which of the following best describes enterprise value (EV)?
   1. The market value of equity alone
   2. Market value of equity plus market value of debt less cash equivalents
   3. The current assets minus current liabilities
   4. Book value of total assets
2. Why must adjustments be made to reported debt and earnings when calculating EV multiples for business valuation?
   1. To increase reported profits
   2. To eliminate double-counting of tax
   3. To ensure comparability between companies
   4. To reduce the market value of equity

3. Give two examples of items that may require adjustment when determining ‘debt’ for enterprise value calculations.

4. What is the main difference between an equity multiple (such as P/E ratio) and an EV-based multiple (such as EV/EBITDA)?

Introduction

Relative valuation using enterprise value (EV) forms a core part of business and asset valuation in ACCA Financial Management. Unlike absolute valuation, which seeks to estimate the fundamental value of a business, relative valuation compares a target business to similar companies or market benchmarks using standardised multiples.

EV-based multiples, especially EV/EBITDA, are widely used because they account for both equity and debt funding, giving a fuller picture of company value that is not distorted by differences in capital structure or depreciation policies. To apply EV-based multiples correctly, you must fully understand how to calculate EV, choose appropriate denominators, and make necessary adjustments for non-operating items, leases, and non-controlling interests.

Key Term: enterprise value (EV)
The total value of a business available to all investors (equity and debt), calculated as market value of equity plus net debt (interest-bearing debt less cash and cash equivalents), adjusted for non-operating assets and other relevant items.

EV-BASED MULTIPLES IN RELATIVE VALUATION

Relative valuation is a method of valuing companies by comparing valuation multiples of similar, publicly-traded firms to the target company. It is popular because it is fast, uses observable market data, and reflects current investor sentiment.

Why Use EV-Based Ratios?

Traditional equity multiples, such as the price/earnings (P/E) ratio, focus only on the returns to shareholders and can be distorted by gearing, capital structure, or non-cash expenses like depreciation. EV-based multiples (such as EV/EBITDA or EV/EBIT) use a value-to-operating-profits approach, making them more suitable for comparing companies with different funding or tax situations.

Key Term: EV/EBITDA multiple
A relative valuation measure that divides enterprise value by earnings before interest, tax, depreciation, and amortisation (EBITDA), showing how many times operating cash flow the business is valued at.

CALCULATING ENTERPRISE VALUE

The basic formula for EV is:

**EV = Market value of equity

• Interest-bearing debt (at market or book value)
• Non-controlling interests (if applicable)
• Preference shares (if treated as debt)
  – Cash and cash equivalents
  – Other non-operating assets (if identified)**

Each component may need to be adjusted to achieve consistency and comparability across companies.

Making EV Adjustments

Common adjustments are required to ensure only debt and cash relevant to the business are included:

• Adjusting Debt:

  • Exclude non-interest-bearing liabilities (such as trade payables and tax provisions)
  • Include finance leases, overdrafts, preference shares (if treated as debt), and possibly pension deficits
  • Adjust debt by removing items like deferred tax if not treated as part of debt in all comparators

• Cash and Equivalents:

  • Only surplus cash or truly liquid investments should be offset; operating/required cash is often excluded

• Non-Operating Assets:

  • Remove any investments, surplus assets, or subsidiary stakes unrelated to core activities

• Non-Controlling Interests:

  • Add back any value of non-controlling interests if group EBITDA is used as the denominator

Key Term: net debt
The sum of all interest-bearing borrowings less cash and cash equivalents; used in deriving enterprise value for valuation multiples.

Key Term: non-operating assets
Assets on the statement of financial position that are not required for core business operations, such as surplus properties or investments.

Worked Example 1.1

A listed company has the following figures in its financial statements:

• Market value of equity: $120 million
• Bank loans and bonds (interest-bearing): $80 million
• Finance leases: $10 million
• Cash and cash equivalents: $20 million
• Surplus investment property: $14 million
• Trade payables: $15 million

Calculate the enterprise value for use in EV/EBITDA multiples.

Answer:

• Market value of equity: $120 million
• Interest-bearing debt: $80m + $10m (finance leases) = $90 million
• Subtotal: $210 million
• Less: Cash and cash equivalents: $20 million
• Less: Surplus investment property: $14 million
• Exclude trade payables (not interest-bearing)
  Enterprise value = $210m – $20m – $14m = $176 million

SELECTING THE RIGHT MULTIPLE

The most common EV-based multiples are:

• EV/EBITDA: Most used. Strips out the effects of capital structure, taxation and non-cash charges. Good for comparing companies with different D&A policies.
• EV/EBIT: Useful when depreciation affects companies differently, or for capital-intensive industries.
• EV/Sales: Sometimes used for companies with no profits, but less meaningful for companies with established earnings.

The chosen multiple should match how the comparator companies are typically valued in the relevant industry.

Ensuring Consistency

For comparisons to be meaningful, the numerator (EV) and denominator (e.g. EBITDA or EBIT) must be measured consistently. If adjustments are made in the numerator (such as excluding surplus cash), corresponding items must also be excluded or included in the denominator.

Making Earnings Adjustments

• Remove non-recurring, exceptional or one-off items from EBITDA/EBIT
• Adjust for different accounting policies (leases, pension costs, etc.)
• Ensure earnings figures are on a pre-interest, pre-tax basis to match EV

Worked Example 1.2

Two companies are being compared using EV/EBITDA. Company A includes a $5 million gain on sale of a major subsidiary in EBITDA, Company B does not. What adjustment should be made?

Answer:
The $5 million gain is non-operating and non-recurring. Adjust Company A's EBITDA by subtracting the $5 million before using it in the EV/EBITDA calculation.

COMPARISON AND INTERPRETATION

After calculation, the target company’s adjusted multiple is compared to those of similar companies or to the industry average.

• If the target’s multiple is higher than peers, the business may be overvalued, or expected to grow faster.
• If lower, it may be undervalued, or expected to face risks or lower profitability.
• Interpret results with caution—multiples reflect both objective and subjective market expectations.

Limitations

• Multiples may be affected by temporary market sentiment.
• Adjustments are often based on judgment and may reduce comparability.
• Cross-border comparisons can be distorted by differences in accounting standards or taxation.

Revision Tip

Always reconcile numerator and denominator. If you adjust debt by adding back operating leases, adjust EBITDA for the lease expense as well.

Summary

Enterprise value-based multiples are essential in relative valuation where capital structures vary. Careful calculation, matched adjustments, and understanding of industry norms are essential to ensure reliable and comparable results. Always use consistent and clearly adjusted data for both EV and profit figures.

Key Point Checklist

This article has covered the following key knowledge points:

• Define enterprise value (EV) and explain its role in company valuation
• Calculate EV and apply adjustments for debt, cash, and surplus assets
• Identify and incorporate the correct earnings figure (EBIT, EBITDA) in multiples
• Make consistent adjustments to both EV and earnings to ensure comparability
• Interpret and compare EV-based multiples across companies
• Recognise strengths and weaknesses of EV-based relative valuation

Key Terms and Concepts

• enterprise value (EV)
• EV/EBITDA multiple
• net debt
• non-operating assets