380  Using Multiples Adjust for Nonoperating Items In a presentation to a group of professional investors, we provided the au- dience with financial data on two companies. We then asked the audience which company traded at a higher EV multiple. The results were surprising. Upon polling the group, we discovered that there was no common agreement on how to compute the EV multiple. A group of 100 professionals generated nearly a dozen different comparisons. Further investigation revealed that the primary cause of this divergence was inconsistency in defining enterprise value. Only one approach to building an EV-to-EBITA multiple is theoretically consistent. Enterprise value should include only the portion of value attribut- able to assets and liabilities that generate (adjusted) EBITA. Strictly speaking, it should be referred to as “net” enterprise value, meaning net of nonoperating assets. Including value, such as the value of joint ventures, in the numerator without including its corresponding income or loss in the denominator will systematically distort the multiple upward. Conversely, failing to recognize a component of enterprise value will understate the numerator and bias the multiple downward. This occurs, for example, when the value of noncontrol- ling interest is not added to the value of common equity. Oracle offers an example of a biased multiple. At the end of September 2019, Oracle had $38 billion of cash and marketable securities. With total debt, pensions, and debt equivalents of $76 billion, as well as equity of $177 billion, it had a gross enterprise value of $253 billion. Subtracting nonoperating cash gives a net enterprise value of $216 billion. With expected EBITA of $19 billion, its gross enterprise value to EBITA would be 13.3 times, while its net enter- prise value to EBITA would be 11.3 times, or 15 percent lower.7 A way to think about the difference is to think of Oracle as a portfolio with two components: one is an operating business that sells software and services, and the other is a pile of cash. The operating business is valued at 11.3 times EBITA, while if the cash earned 1.0 percent pretax, it would be valued at 100 times (the inverse of the earnings yield). The company as a whole is valued at the weighted average of the two multiples, 13.3 times. Since the 13.3 times is a weighted average of two very different numbers, it doesn’t provide any insight into how to think about Oracle’s value. To see how the math provides additional clarity, Exhibit 18.10 presents three companies—A, B, and C—with identical EV-to-EBITA multiples. Com- pany A holds only core operating assets and is financed by traditional debt and equity. Its combined market value of debt and equity equals $900 million. Dividing $900 million by $100 million in EBITA leads to an EV multiple of 9 times. 7 Even if we adjusted EBITA to include income on the cash (say, 1 percent after taxes), its gross enter- prise value multiple would have been roughly the same. Adjust for Nonoperating Items  381 Company B operates a similar business to Company A but also owns $100 million in excess cash and a minority stake in a nonconsolidated subsidiary, valued at $200 million. Since excess cash and nonconsolidated subsidiaries do not contribute to EBITA, do not include them in the numerator of an EV- to-EBITA multiple. To compute a net enterprise value consistent with EBITA, sum the market value of debt and equity ($1,200 million), and subtract the market value of nonoperating assets ($300 million).8 Divide the resulting net enterprise value ($900 million) by EBITA ($100 million). The result is an EV- to-EBITA multiple of 9, which matches that of Company A. Failing to subtract the market value of nonoperating assets will lead to a multiple that is too high. For instance, if you divide debt plus equity by EBITA for Company B, the resulting multiple is 12 times, three points higher than the correct value. Similar adjustments are necessary for financial claims other than debt and equity. To calculate enterprise value consistently with EBITA, you must in- clude the market value of all financial claims, not just debt and equity. For Company C, outside investors hold a noncontrolling interest in a consolidated subsidiary. Since the noncontrolling stake’s value is supported by EBITA, you Exhibit 18.10  Enterprise Value Multiples and Complex Ownership $ million Company A Company B Company C Partial income statement EBITA 100 100 100 Interest income – 4 – Interest expense (18) (18) (18) Earnings before taxes 82 86 82 Gross enterprise value Value of core operations 900 900 900 Excess cash – 100 – Nonconsolidated subsidiaries – 200 – Gross enterprise value 900 1,200 900 Debt 300 300 300 Noncontrolling interest – – 100 Market value of equity 600 900 500 Gross enterprise value 900 1,200 900 Multiples, times Net EV/EBITA 9.0 9.0 9.0 Debt plus equity minus cash/EBITA 9.0 11.0 8.0 Debt plus equity/EBITA 9.0 12.0 8.0 8 Alternatively, we could adjust the denominator rather than the numerator by adding interest income to EBITA. This definition of EV to EBITA is consistent but is biased upward. This is because the multiple for excess cash typically exceeds that of core operations. The greater the proportion of cash to overall value, the higher the resulting multiple.