Match a multiple to its denominator

Learning goals

• Calculate EV/EBITDA.
• Explain why 750 applies to this case.
• Identify the case-specific assumption or failure mode before taking action.

Draft · approximately 45 minutes, excluding further revision.

Shared case and decision context

A company has equity market value 600, debt 200, cash 50 and EBITDA 75. No preferred stock or minority interest exists. A peer’s reported earnings include a large one-time gain; another peer has negative EPS.

Economic or professional mechanism

Enterprise value matches operating metrics available to debt and equity, whereas equity price matches shareholder earnings or book equity. Normalize unusual earnings and align accounting, growth, risk and profitability before applying a peer multiple. A low P/E can reflect weak growth or high risk, not automatic undervaluation.

Apply, challenge and communicate

EV is 750 and EV/EBITDA is 10. Negative EPS makes conventional positive P/E comparisons uninformative; use a justified alternative rather than ranking negative multiples as cheap. EBITDA omits capital spending and working-capital needs, so even a correctly computed multiple is not cash flow.

Fundamental multiples, normalization and aggregation

Comparables infer value from similar assets while fundamental multiples derive from a valuation model. Similar industry labels are insufficient when growth, risk, margins, accounting or reinvestment differ. Under stable clean assumptions, forward P/E=payout/(r−g), P/B=(ROE−g)/(r−g), and P/S=net margin×payout/(r−g). For payout 40%, r 10%, g 4%, ROE 12%, margin 8%, these are 6.6667,1.3333 and 0.5333. P/E at a low payout can still be attractive if reinvestment earns a justified high return; do not maximize growth without funding it.

Normalize cyclical earnings across an economically defensible cycle, adjusting one-off gains and changed capital base; do not erase recurring bad news as exceptional. Price 60/EPS 3 gives P/E 20 and earnings yield 5%; price 60/sales per share 30 gives P/S 2, and dividend 2 yields 3.3333%. Earnings yield can compare negative or near-zero earnings without the same explosive P/E denominator, but losses still require explanation. PEG=20/10=2 when growth is quoted as 10%, with the convention stated; equal PEG does not equate risk or duration.

A cross-sectional prediction such as P/E=8+40 g−2 beta gives 10 for g 10%, beta 1; it is conditional on the sample, omitted variables and out-of-sample stability, not intrinsic truth. At year 3 a forward multiple 15 applied to year 4 EPS 4 implies terminal price 60 at year 3, which must be discounted. Cross-border differences in inflation, taxation, ownership rights and accounting can dominate apparent cheapness. Momentum signals measure price/earnings revision trends and can supplement rather than replace valuation.

For positive P/Es 10 and 20 the arithmetic mean 15 exceeds the equal-weight harmonic mean 13.3333; the median is 15. The harmonic mean corresponds to equal-dollar portfolio earnings aggregation. With value weights 25%/75%, weighted harmonic P/E=1/(.25/10+.75/20)=16. Standardize definitions and exclude or separately analyze unusable denominators rather than applying these means mechanically to mixed-sign multiples.

Use an enterprise-to-common-equity bridge with every claim visible

Original bridge: operating enterprise value is 900; surplus cash is 60; a nonoperating investment is 20; market debt is 250; preferred equity is 30; and fair value of noncontrolling interests is 40. If the operating cash flow and EV include 100% of consolidated subsidiaries, common-equity value is 900+60+20−250−30−40=660. With 60 common shares and no other dilutive claims, value per share is 11. Deduct NCI because its share of consolidated operations was included, not because every balance sheet universally requires that subtraction.

Peer EV/EBITDA comparisons require compatible consolidation and lease treatment. If EBITDA includes 100% of a subsidiary but EV omits its noncontrolling claim, the multiple is understated. Do not add surplus cash that the operating forecast needs as minimum cash, or subtract debt twice through both net debt and a separate gross-debt deduction. Options, pension deficits and cross-holdings require explicit scope and consistency decisions; an unexplained residual line is not a substitute for identifying the claim.

Formula and assumptions

EV=equity value+debt−cash; EV/EBITDA=EV/EBITDA

Case analysis with explicit assumptions

1. A company has equity market value 600, debt 200, cash 50 and EBITDA 75. No preferred stock or minority interest exists. A peer’s reported earnings include a large one-time gain; another peer has negative EPS.
2. Method: EV=equity value+debt−cash; EV/EBITDA=EV/EBITDA
3. Case result: 10.00x. EV is 750 and EV/EBITDA is 10. Negative EPS makes conventional positive P/E comparisons uninformative; use a justified alternative rather than ranking negative multiples as cheap. EBITDA omits capital spending and working-capital needs, so even a correctly computed multiple is not cash flow.

Errors to catch

• Do not replace the stated assumptions with an unstated shortcut. Reconcile units, timing and the claim being valued or duty being assessed.
• All operating revenue is not a defensible conclusion for these case facts.

Original knowledge check

Answer every question before checking. Review explanations after submitting; retry starts a new attempt.

Sources and coverage status

These original lessons are drafts. Public outlines are used to check scope; the official learning-outcome text and proprietary question banks are not reproduced here. Follow the source for exam-year requirements and updates.

• Reference · www.cfainstitute.org
• Reference · www.investor.gov