“Share price reflects the effect of debt financing on profitability and risk. In the P/S multiple, however, price is compared with sales, which is a prefinancing income measure–a logicla mismatch. For this reason some experts use a ratio of enterprise value to sales because enterprise value incorporates the value of debt.”
Doesn’t share price also incorporate the value of debt? It says it --“Share price reflects the effect of debt financing on profitability and risk.”
This whole thing doesn’t make sense to me, why is enterprise value better in this case?
Enterprise value = market cap - cash and cash equivalents + debt, minority interest and preferred shares.
If a Co is not leverged …Total euity then it doesn’t make a difference…
Now if the Co has a debt…that means on All sales the debt holders also HAVE A CLAIM since they also provided the finance . As EV included the debt value…so its alot more relevent to use EV / Sales…rather than Price ( which only represent the Euity value ) would be more appropriate for NET Income(EPS) when all the debt holders( finance COST ) has been paid. so Net income is only for Equity holders…
Thats why we use EV instead of P…but you might have seen P/S ratio a lot…BUT theoratically EV makes the sense.
Enterprise Value is used primarily for acquisitions. When you acquire a company, you have to pay a premium to the equity value (what P/E directly measures) but you also have to assume the debt of the acquired company. As the last poster said, the debt investors have a claim and they aren’t going to take a loss by the value of that debt going to $0 just because the company was acquired. If you want to acquire a company, you have to (a) pay a premium to the market value of the equity AND (b) you have to assume the debt, too, which is why Enterprise Value is used in M&A.
P/E most directly measures the value of equity. If you buy a share of McDonalds common stock, you’re buying an equity stake and you’re not directly responsible for paying the debts of the company (use P/E). If you buy the entire company of McDonalds, you’re now directly responsible for their debt, too (you’d use EV).
However, when you’re buying a common share of equity you may just use P/E as a valuation metric valuing the equity, but you need to be congnisant that the debt investors in the capital structure have a priority claim on the company’s assets and cash flows and P/E does not directly account for that making it less useful for companies that use a lot of debt (although a high interest expense due to high debt reduces EPS)