Market Capitalization vs. Enterprise Value – Yield or times ratios – What is the best to use?

Quantitative-Investing

Market cap ignores debt. Two companies with identical earnings but very different debt levels will have the same P/E ratio - yet one is far more expensive to own than the other.

Enterprise value fixes this. Here is how to use it to compare companies properly.

Different types of valuation ratios

When you see a company’s P/E ratio you may know it shows a company’s valuation comparing its market value to its after tax profits.

You also know what earnings before interest and taxes (EBIT) and earnings before interest, taxes, depreciation, and amortisation (EBITDA) from seeing them a few times I am sure. But do you know these numbers can be also be used to value and compare companies you are thinking of buying?

When using these ratios, it is important to understand how each shows a different part of a company’s income statement and that affects their usefulness. Some valuation ratios work better than others and understanding these basics can help you choose the best companies that meet your investment strategy.

Start with the familiar P/E

Let’s start with one of the most common valuation ratios.

The Price to earnings or P/E ratio is calculated as follows:

P/E ratio = price per share / earnings per share (EPS)

You can calculate EPS as follows:

EPS = Net Income after Tax / total shares outstanding

Instead of using per share values you can also calculate the P/E ratio like this:

P/E = Market Capitalization / Net Income

Market capitalization = share price x number of outstanding shares

You can see that the price to earnings ratio (P/E ratio) measures the level of a company’s stock price relative to its after tax profit per share, and you can use it to get an idea of a company’s valuation.

For example, a company is trading at 15 times after tax profits has a P/E ratio of 15.

What about EBIT and EBITDA

Earnings Before Interest and Taxes (EBIT) describe a company's profitability as sales minus operating expenses (OPEX). It is also known as operating income and you calculate it as follows:

EBIT = Sales – Cost of Sales - Operating Expenses (calculating from the top of the income statement)

EBIT = Net Income + Interest + Taxes (calculating from the bottom of the income statement)

Earnings before interest, taxes, depreciation, and amortization (EBITDA), on the other hand, show you operating profit without depreciation and amortization (both non-cash expenses).

You can use it to get an idea of the cash profits or as close to it a company makes.

This makes it helpful to compare to the debt levels of highly leveraged companies or very capital intensive companies with high levels of depreciation.

Because of high depreciation and interest these companies often report losses, and you can use EBITDA to show the earnings available to pay debt.

This is how EBITDA is calculated:

EBITDA = Operating Profit + Depreciation Expense + Amortization Expense

EBITDA = Net Profit + Interest +Taxes + Depreciation + Amortization

Both EBIT and EBITDA show profits available to equity and debt holders, because they show income before deducting interest payments on debt.

Neither is a standard accounting measure under GAAP (US) or IFRS (Europe), which is why you will not find them as a line item in financial statements — but both are widely used by analysts and fund managers precisely because they are comparable across companies.

Enterprise Value

The Enterprise Value (EV) gives you a better idea of the total market value of a company as it takes the capital structure of a company into consideration.

Capital structure simply means how the company is financed for example equity debt, minority interest, preferred shares and cash.

Enterprise value is calculated like this:

EV = market value of common stock + market value of preferred equity + market value of debt + minority interest - cash and investments

You can think of it as the total price you have to pay if you want to buy the whole company. If you buy a company you can pay out the cash, redeem preferred stock, pay back bank loans, buy back bonds, so, EV more closely represents the company’s value.

In terms of valuing companies, EV is higher for companies with a lot of debt and little cash and a lower for companies with little debt and plenty of cash.

Ratios Using Enterprise Value (EV)

As EV gives you a more complete idea of the value of a company it is a good value to use in the valuation of a company.

For example it can be used to calculate EBIT/EV which we call Earnings Yield.

As you can see it uses EBIT and thus gives you a clean, realistic estimate of operating income and compares it to enterprise value.

Earnings Yield = Operating Income or earnings before interest and taxes (EBIT) / Enterprise Value

The same way you can calculate EBITDA Yield:

EBITDA Yield = EBITDA / Enterprise Value

Why the Same P/E Can Mean Two Very Different Things

Here is a simple example that shows exactly why enterprise value gives you a more accurate picture than market capitalisation alone.

Imagine two companies — Company A and Company B. Both are manufacturing businesses. Both have a market cap of €500 million and both earned €50 million in net profit last year. Their P/E ratio is identical: 10 times earnings.

On the surface they look equally priced. But look at their balance sheets and a very different picture emerges:

	Company A	Company B
Market capitalisation	€500m	€500m
Debt	€300m	€20m
Cash	€30m	€180m
Enterprise Value (EV)	€770m	€340m
Net income (after tax)	€50m	€50m
P/E ratio	10x	10x
EBIT (operating income)	€82m	€68m
Earnings Yield (EBIT / EV)	10.6%	20.0%

Company A has €300 million of debt and barely any cash. To buy the whole business you would need to pay €770 million — €500 million for the shares plus take on €300 million of debt, minus only €30 million of cash you could use.

Company B has almost no debt and €180 million sitting in the bank. To buy the whole business you would pay just €340 million once you account for the cash you receive.

The P/E ratio tells you they cost the same. The earnings yield tells you Company B earns nearly twice as much relative to what you actually pay for it.

Company A's EBIT is slightly higher than Company B's because it pays interest on its debt — interest reduces net income but not EBIT, which is why using EBIT rather than net income gives you a cleaner comparison between companies with different debt levels.

This is exactly why EV-based ratios like earnings yield are more reliable than P/E when comparing companies across different capital structures — which in practice means almost every comparison you will ever make.

Screen using EV-based valuation ratios across thousands of stocks — free trial

The Quant Investing screener includes EV/EBIT, EV/EBITDA, EV/FCF, earnings yield and more than 110 other ratios — all calculated consistently across European, US and Asian markets.

You can combine any of them into a single ranked screen in minutes.

Try it free for 30 days. Includes the screener, the historical back tester, a 74-page eBook on European market strategies, and our Best Ideas Newsletter.

Try the EV ratio screener free — 30 days

No credit card needed. Cancels automatically after 30 days.

When to Use a Yield or a Times Ratio

I am sure you have also seen ratios shown as a yield (with a percentage sign like EBIT / EV = 12%) or shown as times (for example PE = 5 times (the stock price is equal to 5 times earnings).

A yield ratio refers to income or return on an investment.

For example, earnings yield, described above, refers to the EBIT/EV. Likewise, the interest rate or dividend yield you received from holding a particular security is a yield.

Yield ratios are useful because you can easily use them to compare the returns of different companies. And allows you to easily compare the rate with the return on other assets, for example bond yields, interest rates or a real estate capitalisation rate.

If you look at multiple or times ratios like P/E it is not a yield but it tells you that you have to for example pay seven years’ worth of earnings for a company with a P/E ratio of 7.

This is also easy to understand but more difficult to compare to other investments prices in percentages like interest rates and bond yields.

Summary and conclusion

For most stock screening purposes, earnings yield (EBIT/EV) is the most useful starting point because it accounts for capital structure, uses pre-tax operating income that is harder to manipulate, and produces a percentage you can directly compare to bond yields and interest rates. If you are screening highly indebted or capital-intensive companies, EBITDA yield adds value by removing depreciation.

P/E remains useful for a quick sanity check but should never be used alone to compare companies across different capital structures.

Start searching using EV-based valuation ratios — free trial