When you start to learn valuation, your professor will tell you there are three approaches to evaluate a company, CASH FLOW/INCOME METHOD, MARKET COMPARABLE METHOD, and CONTROL TRANSACTIONS METHOD.
We usually start learning from cash flow/income approach. After Free Cash Flows mess up your spreadsheet, you may find multiples are easier to apply. There are 2 types of multiples, OPERATING and EQUITY. Using operating multiples, such as Enterprise Value (EV)/EBITDA, you will get total Enterprise Value. If you use equity multiples, such as Price/Earnings, you will have Equity Value.
ATTENTION! You need to make sure your multiples are “apples to apples” base. Market Cap / EBITDA will not be an “apples to apples” case since Market Cap is Market Value of Equity, and EBITDA is related to the whole operation of a company.
After you choose the appropriate multiples, you are relieved. But “apples to apples” thing does not end here. Since Enterprise Value itself is somehow tricky. Some analysts calculate it with excess cash, and some don’t, so it is better to make sure how the multiple you are using is calculated.
Here is an example from http://valuationacademy.com:
For example, imagine the Director of Corporate Development at Apple is considering the acquisition of T-mobile to vertically integrate its iPhone offering. The director phones the MD at Morgan Stanley asking him for some multiples in the wireless carrier industry and the new analyst at Morgan Stanley is thrown on the task. The analyst opens up his database and calculates the transaction multiples using historical earnings data of the acquired companies and the total price of the transaction including all excess cash. The corporate development director at Apple receives the multiples, and assumes they measure the multiple of the total firm value void of cash. He opens up the T-mobile 10k, multiplies the earnings by the multiples he was given and adds the amount of cash to T-mobiles balance sheet to get an idea of how much Apple is expected to pay out for the entire company.
In this scenario, the Director of Corporate Development was using an incorrect multiple in his analysis. He added the cash on T-mobile’s books to arrive at total price Apple should pay for the company when the multiples that the Morgan Stanley analyst computed already took cash into consideration. The Director at Apple double counted cash, paid too much for T-Mobile.
Remember, “Apples to Apples” rule, comparing two things that are similar and comparable.
By the way, this rule also works when you do financial statement analysis. You need to be careful whether a company changes its definition of metrics. For example, a company may include A item in the calculation of EBITDA last year, but exclude it this year to make the number look better.