Before you start
You will be able to
- Distinguish book value from market value, and explain why the two usually differ.
- Calculate market capitalisation and enterprise value, and explain why enterprise value adds debt and subtracts cash.
- Calculate EBIT and EBITDA from an income statement, and explain what EBITDA leaves out.
- Calculate and interpret the EV/EBITDA and P/E multiples, matching each numerator with the right measure of earnings.
- Estimate a value range from peer multiples and explain how the result depends on the assumptions chosen.
Review first
- Capital and liquidity — You need debt, equity and Harbourline’s balance sheet from that lesson.
- What revenue, expenses and net income are: what a business earns from customers, what it costs to earn it, and what is left. F01 Introduction to Financial Accounting covers them in depth.
Fictional case A fictional coffee business founded by Ana Lim. It starts as a catering and barista-training service, opens its own cafés and an online shop for beans, and plans a canned cold brew.
The idea
Fictional case
In February 2026, a few weeks before Lantern opens, Ana reads the annual report of Harbourline Roasters Inc., a listed coffee roaster that could one day supply her beans. One page says Harbourline’s shareholders’ equity is $300 million. A financial news site says the company is worth $765 million. A second site, comparing coffee companies, lists Harbourline at $930 million and “10.0× EBITDA”. All three are about the same company on the same day. None of them is a mistake: each answers a different question, and this lesson is about telling the questions apart.
A valuation is an estimate of what something is worth: a share, a whole company, a building, a café. Finance has a small vocabulary for doing it, and the words are used precisely. Some describe what the accounts record; some describe what the market is paying; some describe how much a business earns; and some, called multiples, relate a price to earnings so that companies of different sizes can be compared.
Book value and market value
The book value of equity is the shareholders’ equity recorded in the balance sheet: total assets minus total liabilities, measured by the accounting rules. Harbourline’s is $300 million (from the balance sheet in the previous lesson: assets of $660 million minus liabilities of $360 million). Accountants also speak of the book value of a single asset, meaning its cost less the depreciation recorded so far; in this lesson “book value” means book value of equity unless stated otherwise.
The market value of something is what buyers and sellers are paying for it now. For a listed company the market value of its equity is called its market capitalisation (market cap): the share price times the number of shares outstanding. Harbourline has 18 million shares trading at $42.50, so its market capitalisation is million dollars. Investor.gov defines it in the same way: the current market price of one share multiplied by the total number of shares outstanding.
Why is the market paying $765 million for equity the accounts record at $300 million? Because the two numbers look in different directions. The balance sheet mostly records what assets cost when they were bought, and leaves out valuable things the business built itself, such as its brand, its relationships with growers and the skills of its roasters. The share price reflects what investors expect the company to earn in the future, discounted for time and risk. Their ratio, the market-to-book ratio, is : investors pay $2.55 for every dollar of recorded equity. Per share, book value is dollars against a price of $42.50.
Enterprise value: the price of the whole business
Market capitalisation prices only the shares. Suppose you wanted to buy all of Harbourline’s operations: its roasting plants, its brand, its customers. Buying every share would cost $765 million, but you would also take on its $210 million of debt, which the lenders will still expect to be repaid. In exchange, you would get the $45 million of cash in its bank accounts, which you could use straight away to pay part of that debt. The net cost of the business is its enterprise value (EV):
Think of buying a house that comes with a $200,000 mortgage you must take over and $5,000 left in a drawer. If you pay the seller $300,000, the house really costs you dollars. Enterprise value applies the same logic to a company. The debt minus the cash, $165 million for Harbourline, is called net debt, so enterprise value is also market capitalisation plus net debt.
The figure shows the second way to read enterprise value: it is the value of the operating business, which is shared between everyone who financed it. Lenders and shareholders both have claims on it; cash is subtracted because it is not part of the operations and could be paid out tomorrow without changing what the business does. This is why enterprise value is the natural measure when comparing companies that are financed differently.
Measures of earnings: EBIT, D&A and EBITDA
To judge whether a price is high or low, you compare it with what the business earns. An income statement subtracts costs from revenue in stages, and finance gives names to some of the stages. EBIT (earnings before interest and taxes) is what the business earns before paying its lenders and the government. For a company with no income or costs outside its operations, such as Harbourline, EBIT equals operating profit; otherwise the two differ. D&A is depreciation and amortisation: depreciation spreads the cost of physical assets such as roasting machines over the years they are used, and amortisation does the same for intangible assets such as purchased software licences or customer contracts. Neither is a cash payment in the year it is recorded; the cash left when the asset was bought. EBITDA (earnings before interest, taxes, depreciation and amortisation) adds D&A back to EBIT.
| Line | $ millions | What it means |
|---|---|---|
| Revenue | 640 | Sales of coffee to cafés, offices and supermarkets |
| Operating costs excluding D&A | (547) | Green coffee, wages, energy, packaging, transport, rent |
| EBITDA | 93 | Earnings before interest, taxes, depreciation and amortisation |
| Depreciation and amortisation | (32) | Spreading the cost of roasters, plants and software |
| EBIT (here equal to operating profit) | 61 | Earnings before lenders and taxes |
| Interest | (11) | Paid to lenders on the $210 million of debt |
| Profit before tax | 50 | |
| Income tax | (12) | A 24% rate on profit before tax |
| Net income | 38 | What is left for shareholders |
All figures come from the course case. Amounts in parentheses are subtracted.
Harbourline’s EBITDA is million dollars, or of revenue (its EBITDA margin). Working upwards from the bottom gives the same answer: . The US Securities and Exchange Commission’s staff take exactly that route when they say how EBIT and EBITDA should be calculated in company filings: “earnings” means net income as reported under GAAP, with interest, taxes and (for EBITDA) depreciation and amortisation added back.
Multiples: price compared with earnings
A valuation multiple divides a measure of value by a measure of what the business earns, so that a large company and a small one can be compared. Two are used everywhere.
- EV/EBITDA divides enterprise value by EBITDA. Harbourline: . The whole business is priced at ten times one year’s EBITDA.
- The P/E ratio (price-to-earnings) divides market capitalisation by net income, or equivalently the share price by earnings per share (EPS). Harbourline’s EPS is dollars, and its P/E is . Shareholders are paying about twenty times one year’s earnings.
In depth
Why enterprise value adds debt and subtracts cash: the careful version
Enterprise value aims to measure the value of a company’s operations, independent of how they are financed. Two companies with identical roasting plants, customers and costs should have the same enterprise value (ignoring the tax saving on interest) even if one borrowed heavily to build its plants and the other used shareholders’ money. Their market capitalisations will differ, because in the borrowing company the lenders own a larger slice of the same pie, but adding the debt back puts them on the same footing.
Cash is subtracted because cash is not an operating asset in this sense. A company holding $45 million of spare cash is worth $45 million more to its shareholders than an otherwise identical one without it, and that $45 million says nothing about how good its roasting business is. Strictly, analysts subtract only cash not needed to run the business day to day, and they add other claims on the business besides ordinary shares, such as preferred stock, lease obligations and the share of subsidiaries owned by outside shareholders (noncontrolling interests). Those refinements are left to later courses; the core idea is debt in, spare cash out.
The table compares Harbourline with Northbay Roasters, a fictional twin that has the same operations, the same cash and the same 24% tax rate, but no debt. Suppose the market values the two businesses’ operations equally.
| Harbourline | Northbay (no debt) | |
|---|---|---|
| Enterprise value | 930 | 930 |
| Debt | 210 | 0 |
| Cash | 45 | 45 |
| Market capitalisation (EV − debt + cash) | 765 | 975 |
| EBITDA | 93 | 93 |
| EV/EBITDA | 10.0 | 10.0 |
| Net income (EBIT − interest − tax at 24%) | 38 | 46.4 |
| P/E | 20.1 | 21.0 |
EV/EBITDA is identical, because neither enterprise value nor EBITDA depends on how the business is financed. The P/E ratios differ, although the businesses are the same: Northbay pays no interest, so its net income is higher (), and its shares carry less risk. That is the main reason analysts prefer EV-based multiples when comparing companies with different amounts of debt, and use P/E mainly between companies financed in similar ways.
What EBITDA leaves out
EBITDA is popular because it is a rough proxy for the cash the operations generate before interest, tax, replacement spending and working-capital needs, and because it is unaffected by financing, tax and depreciation choices. Those same features are its limits. Each letter in the name is something the business really does have to pay or replace.
- Depreciation and amortisation stand for real spending. D&A is not a cash payment this year, but machines wear out and must be replaced. Harbourline spends about $35 million a year on new roasting equipment (its capital expenditure, from the course case). Its EBITDA of $93 million overstates what the business can pay out year after year; after that spending, million dollars remain.
- Interest and tax are paid in cash. A business with high EBITDA and heavy debt can still be unable to pay its lenders. That is why lenders look at interest payments as well.
- Working capital needs cash. A growing roaster must buy more green coffee and wait longer for customers to pay. EBITDA ignores that money tied up in current assets.
- EBITDA is not a GAAP measure. Neither US GAAP nor IFRS defines it, so companies can calculate it differently. Many report an “adjusted EBITDA” that adds back costs management calls unusual. The SEC staff’s guidance says a measure calculated differently from net income plus interest, taxes, depreciation and amortisation should not be called EBITDA, and should carry a different title such as “Adjusted EBITDA”.
None of this makes EBITDA useless: it is a reasonable starting point for comparing similar businesses. It does make EBITDA a poor stand-in for cash flow or profit on its own. A careful analyst always asks what each company’s capital spending and working capital needs are, and how any adjusted figure was built.
Valuation depends on assumptions
There are two broad ways to estimate what a company is worth. Relative valuation uses multiples: find similar companies (comparables, or comps), see what multiples the market pays for them, and apply those multiples to the company being valued. Intrinsic valuation forecasts the cash the business will generate and discounts it to today using the time value of money from lesson 1; F05 Corporate Finance teaches that method. Both rest on judgements.
For relative valuation the judgements include which companies count as comparable, which year’s earnings to use (last year’s, called trailing, or next year’s forecast, called forward), whether to use reported or adjusted earnings, and where in the peers’ range the company deserves to sit. OpenStax’s Principles of Finance stresses that a single multiple means little without comparison to peers or history, that it is a snapshot in time, and that analysts should combine several measures. Worked example 2 shows how far the answer moves when the assumptions do.
For intrinsic valuation the judgements are the forecasts themselves (sales growth, margins, spending) and the discount rate. Small changes in either can move the answer a long way. Neither method produces the value of a company; each produces an estimate conditional on stated assumptions. A good valuation states those assumptions openly, so that a reader can disagree with them and see what happens to the answer.
Formulas
Market capitalisation
- Current share price$ per share
- Number of shares outstandingshares
Assumes. Uses the latest traded price; changes whenever the price does.
The market value of the company’s equity.
Enterprise value
- Market value of the equity$
- Interest-bearing debt: loans and bonds$
- Cash and short-term investments not needed to run the business; this course subtracts all cash$
Assumes. Debt at its balance sheet amount, a common simplification.
Debt minus cash is net debt, so EV = market cap + net debt. Fuller versions also add preferred stock, leases and noncontrolling interests (outside shareholders’ shares of subsidiaries).
EBITDA
- Earnings before interest and taxes: net income + interest + taxes (equal to operating profit when, as at Harbourline, there is no income or cost outside operations)$
- Depreciation and amortisation for the period$
Assumes. Both from the same period’s income statement.
Not a GAAP or IFRS measure. Check how any “adjusted” EBITDA was built.
EV/EBITDA multiple
- Enterprise value$
- Usually the last twelve months or the next year’s forecast; must be positive to be meaningful$
Assumes. Numerator and denominator both belong to all providers of capital.
Read as “times”: 10.0× means the business is priced at ten years of current EBITDA.
Price-to-earnings (P/E) ratio
- Share price$ per share
- Earnings per share$ per share
- Shares outstandingshares
- Share price × shares outstanding$
- Profit after interest and tax; must be positive for a meaningful P/E$
Assumes. Numerator and denominator both belong to shareholders.
Reported EPS uses a weighted average share count and deducts preferred dividends; this course ignores those refinements.
Market-to-book ratio
- Market value of the equity$
- Total assets minus total liabilities, as recorded$
Assumes. Book value is positive.
Also called price-to-book (P/B) when calculated per share.
Worked examples
Fictional figures
Harbourline has 18 million shares at $42.50, debt of $210 million, cash of $45 million, EBIT of $61 million and depreciation and amortisation of $32 million. Calculate its market capitalisation, enterprise value and EBITDA.
- Market capitalisation is share price times shares outstanding: , so $765 million.
- Enterprise value adds debt and subtracts cash: , so $930 million. Equivalently, net debt is and .
- EBITDA adds D&A back to EBIT: , so $93 million.
- EV/EBITDA follows: .
Answer. Market cap $765 million; enterprise value $930 million; EBITDA $93 million (EV/EBITDA 10.0×).
What it means. Buying the whole business would cost about $930 million net of its cash, about ten years of its current EBITDA. Whether that is a fair price depends on how Harbourline’s growth, risk and spending compare with other roasters’.
Fictional figures
An analyst values Harbourline against three listed roasters (fictional) trading at 8, 10 and 12 times EBITDA. Their P/E ratios range from 15 to 22. Using Harbourline’s EBITDA ($93 million), net income ($38 million), debt ($210 million), cash ($45 million) and 18 million shares, find the range of value per share implied by each multiple, and compare it with the $42.50 share price.
- EV/EBITDA, low end: implied EV . Equity value is EV minus debt plus cash: . Per share .
- EV/EBITDA, high end: implied EV ; equity ; per share .
- P/E gives equity value directly, because both P and E belong to shareholders: low end , per share ; high end , per share .
- Compare: the share price of $42.50 sits inside both ranges; at the middle peer multiple of 10× EBITDA it is exactly the market price, because Harbourline itself trades at 10.0×.
- Judgement: the EV/EBITDA range runs from about $32 to $53 a share, a spread of over $20, from one reasonable-looking choice of peers. Narrowing it requires reasons, such as faster growth or lower capital spending than the peers, for placing Harbourline high or low in the range.
Answer. EV/EBITDA of 8–12× implies about $32.17–$52.83 a share; P/E of 15–22× implies about $31.67–$46.44 a share. The market price of $42.50 lies within both ranges.
What it means. Multiples give a range, not a number. Moving from the 8× peer to the 12× peer changes the implied value per share by about 64%; the choice of peer is an assumption as consequential as any forecast. Note also the step from EV back to equity: debt is subtracted and cash added, the reverse of the EV formula.
Fictional figures
Fernhill Capital, a fictional private-equity fund, is negotiating to buy Copperloaf Bakeries, a fictional private chain of 40 bakeries. Copperloaf’s owners present “adjusted EBITDA” of $14 million, which adds back $2 million of costs they call one-off; the fund’s own review finds that similar costs occur every year, and puts EBITDA at $12 million. Similar bakery chains have recently been bought at about 7 times EBITDA. Copperloaf has $30 million of debt and $5 million of cash. What would the fund pay for the shares on each view of EBITDA?
- On the owners’ figure: EV , so $98 million; equity value , so $73 million.
- On the fund’s figure: EV ; equity value , so $59 million.
- The difference is million dollars: the $2 million of disputed costs multiplied by 7.
- Judgement: because the price is a multiple of EBITDA, every dollar of EBITDA is worth seven dollars of price. The fund should insist on evidence for every add-back, and might also adjust for the chain’s capital spending, since ovens and shop fit-outs must be replaced.
Answer. About $73 million for the shares on the owners’ adjusted EBITDA, or $59 million on the fund’s figure: a $14 million gap.
What it means. The argument in this negotiation is not about arithmetic; it is about which earnings figure is right. That is typical: in most real valuations the assumptions, not the formulas, decide the answer.
Explore
Common mistakes
“Book value is what the company is worth.”
Book value is what the accounts record, mostly at historical cost, and it leaves out much of what makes a business valuable, such as its brand and customer relationships. Harbourline’s book equity is $300 million while the market values its shares at $765 million. Neither is “the” value, but book value is rarely a good estimate of what a buyer would pay. Some texts call a share trading above book value ‘overvalued’; for most healthy firms market value exceeds book because the balance sheet omits internally built value.
“Enterprise value subtracts debt, because debt reduces value.”
It is the other way round. Enterprise value adds debt to market capitalisation, because a buyer of the whole business takes on the debt as well as buying the shares. It is when you go from enterprise value back to the value of the shares that you subtract debt (and add cash).
“EBITDA is the company’s cash flow.”
EBITDA ignores the cash spent replacing equipment, the cash tied up in growing inventory and receivables, interest and tax. A business can report strong EBITDA and still run short of cash. Treat EBITDA as a starting point for comparing similar businesses, not as cash in the bank.
Mixing enterprise and equity measures in one multiple
Dividing market capitalisation by EBITDA, or enterprise value by net income, compares numbers that belong to different groups of investors. The first makes heavily indebted companies look cheap; the second makes them look expensive. Pair EV with measures before interest, and market capitalisation with net income.
“A P/E of 12 is cheaper than a P/E of 20.”
Only if everything else is equal, and it rarely is. A low P/E may reflect expected decline, higher risk or a one-off boost to this year’s earnings; a high one may reflect strong expected growth. P/E also depends on how much debt a company carries. Compare multiples between genuinely similar companies, and ask why they differ.
“The model gave the value.”
Every valuation, by multiples or by forecasts, is the output of assumptions: which peers, which year’s earnings, which adjustments, which growth rate. Change them and the value changes, often by a lot. State the assumptions, and show what the answer would be under reasonable alternatives.
Guided practice
Work through these with hints when you need them. Every hint and every worked solution is there to be used.
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On your own
No hints this time. Answer, check, and read the feedback; the solution appears once you have answered or if you ask for it. Your first answers count toward mastery.
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In practice
Valuation words appear wherever ownership of a business changes hands or money is lent against it. Here is how three professionals use them.
An equity analyst at a fund deciding whether to buy Harbourline shares builds a table of listed coffee and food companies with their market capitalisations, enterprise values, EV/EBITDA and P/E. She removes companies whose businesses differ too much (a café chain earns money differently from a roaster), checks how each company defines any adjusted figure, and notes which companies carry heavy debt, since their P/E ratios are not comparable with Harbourline’s. Harbourline’s 10.0× EV/EBITDA turns out to be in the middle of its peers. Whether that is attractive depends on her view of its growth and spending, which she sets out in a short note with the assumptions stated, so her colleagues can challenge them.
A corporate banker lending to a company looks at the same vocabulary from the lender’s side. Banks often express how much a company has borrowed as a multiple of its EBITDA, and loan agreements often limit it. On the lesson’s figures, Harbourline’s debt is times its EBITDA, and its net debt times. The banker also looks at enterprise value: debt of $210 million against a business valued at $930 million leaves a large cushion of shareholders’ value that would be lost before the lenders lost anything.
Fictional case
Ana uses the words too, on a small scale. In five years, if Lantern is profitable, a larger coffee or catering company might offer to buy it. The buyer would probably value Lantern at a multiple of its EBITDA, subtract Lantern’s debt, add its cash, and offer the rest to Ana for her shares. Knowing that, Ana can see now which decisions would raise that price (steady, well-documented earnings; equipment kept in good order; customer contracts that would survive a change of owner) and why her $20,000 of book equity may turn out to be worth much more, or less, than $20,000.
In each case the same discipline applies: calculate the measures correctly, pair numerators with the right denominators, know what each measure leaves out, and treat every value as conditional on its assumptions.
Knowledge check
Six questions, one attempt each, no hints. Score 80% or more to complete the lesson; you can take it again at any time.
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Summary
- Book value of equity is what the accounts record (assets minus liabilities); market value is what investors are paying now. Harbourline: $300 million book, $765 million market, a market-to-book ratio of 2.55.
- Market capitalisation is share price times shares outstanding: the market value of the equity.
- Enterprise value = market cap + debt − cash: the net cost of buying the whole operating business, shared between lenders and shareholders. Harbourline: $930 million.
- EBIT is earnings before interest and tax (equal to operating profit for Harbourline); EBITDA adds back depreciation and amortisation. Harbourline: $61 million and $93 million.
- EBITDA is not cash flow and not a GAAP measure: it ignores replacement spending, working capital, interest and tax, and adjusted versions vary.
- Pair EV with measures before interest (EV/EBITDA, 10.0× for Harbourline) and market cap with net income (P/E, about 20.1×). EV multiples compare differently financed firms more fairly.
- Every valuation depends on assumptions: peers, earnings definitions, forecasts and discount rates. State them and show how the answer changes.
Key formulas
- Market capitalisation
- Enterprise value
- EBITDA
- EV/EBITDA multiple
- Price-to-earnings (P/E) ratio
- Market-to-book ratio
Terms introduced
- Valuation
- An estimate of what an asset, share or business is worth, made with stated methods and assumptions.
- Book value of equity
- Shareholders’ equity as recorded in the balance sheet: total assets minus total liabilities, measured by the accounting rules.
- Market value
- What buyers and sellers are paying for something now. For a listed company’s equity it is the market capitalisation.
- Market capitalisation
- Share price multiplied by the number of shares outstanding: the market value of a company’s equity. Often shortened to market cap.
- Market-to-book ratio
- Market capitalisation divided by the book value of equity (or price per share divided by book value per share). Also called price-to-book.
- Enterprise value
- Market capitalisation plus debt minus cash: the value of a company’s operating business, claimed jointly by its lenders and shareholders. Often shortened to EV.
- Net debt
- Debt minus cash. Enterprise value equals market capitalisation plus net debt.
- EBIT
- Earnings before interest and taxes: profit before paying lenders and tax. For a company with no income or costs outside its operations, EBIT equals operating profit; otherwise the two differ.
- D&A
- Depreciation and amortisation: the part of the cost of long-lived physical and intangible assets charged as an expense in the period.
- Amortisation
- The spreading of the cost of an intangible asset, such as purchased software or a customer contract, over the years it is used. The word is also used for the gradual repayment of a loan’s principal.
- EBITDA
- Earnings before interest, taxes, depreciation and amortisation: EBIT plus D&A. A widely used but non-GAAP measure of operating earnings.
- Valuation multiple
- A ratio of a measure of value (such as enterprise value or market capitalisation) to a measure of earnings or size (such as EBITDA or net income), used to compare companies.
- EV/EBITDA
- Enterprise value divided by EBITDA: a multiple that compares differently financed companies on the same footing.
- P/E ratio
- Price-to-earnings ratio: share price divided by earnings per share, or market capitalisation divided by net income.
Sources
- Dahlquist, J. & Knight, R. (2022). Principles of Finance, section 6.5, “Market Value Ratios”. OpenStax. openstax.org/books/principles-finance/pages/6-5-market-value…
- Dahlquist, J. & Knight, R. (2022). Principles of Finance, section 11.1, “Multiple Approaches to Stock Valuation”. OpenStax. openstax.org/books/principles-finance/pages/11-1-multiple-ap…
- US Securities and Exchange Commission, Division of Corporation Finance. Non-GAAP Financial Measures: Compliance and Disclosure Interpretations, Question 103.01 (EBIT and EBITDA). Last updated 13 December 2022. sec.gov/divisions/corpfin/guidance/nongaapinterp.htm
- US Securities and Exchange Commission, Office of Investor Education and Advocacy. Market capitalization (glossary). Investor.gov. investor.gov/glossary/glossary_terms/market-capitalization