Enterprise Value to Earnings Ratio

Market performance measures allow the investor-analyst to understand the company's ability to achieve their high level business profitability objectives. This is usually assessed by examining metrics such as insider transactions, capture ratios, enterprise value, capitalization rates and price to earnings ratios. Market performance metrics provide analysts with a way to determine if a company is going to successfully execute their business plan. One of the ways to compare the performance of two companies with very different market capitalization values is by calculating each company's enterprise value to earnings ratio.

Enterprise value is the theoretical cost to purchase a company. It includes the price paid to purchase all outstanding stock (both common and preferred) as well as pay off all the debt of the company. From this total, the analyst would subtract the cash and marketable securities owned by the acquired company, since these funds could be used to help offset the purchase cost.

The enterprise value to earnings ratio takes this net cost to acquire and divides it by earnings adjusted for the extinguishing of debt (Net Income - Interest Expense). This ratio essentially takes the value of the company and divides it by its profitability. Since the ratio is normalized using earnings, it can be used to fairly compare companies of various sizes. When comparing two or more companies, the company with the lower ratio is outperforming the company with the higher value. The ratio theoretically represents the number of years it would take for earnings to equal enterprise value.

It's also possible to examine this ratio in the inverse - dividing earnings by enterprise value. When modeled this way, the ratio would represent the theoretical return if an investor purchased the entire company.

A mutual fund manager wanted to compare the performance of Company ABC to Company ZYX. While both companies competed in the same industry, simply comparing earnings was meaningless since the market capitalization of each firm was very different. In order to make a fair comparison, the fund manager asked his analytical team to calculate the enterprise value to earnings ratio for each company. The information used to make this comparison appears in the table below:

The above analysis confirmed the beliefs of the fund manager. Although only around one-fifth the size of Company ABC, Company ZYX was producing better results.