Unpacking the Enterprise Valuation Question

The valuation of a business enterprise is determined largely by asking a simply question, "What is the present value of the sum of all of the periodic net cash flows I expect this enterprise to generate in the future?"

First, what is a "periodic net cash flow" of the enterprise?  The typical measurement of an enterprise's cash flow is Earnings Before Interest, Taxes, Depreciation and Amortization, or "EBITDA."  This is a measurement of enterprise cash flow available to all capital stakeholders (equity interest holders, lenders, etc) before income taxation (unique tax attributes of an enterprise, to the extent they exist at all, are typically valued separately) over a period of time, typically a year. Required capital expenditure, a cash flow item not included in EBITDA, is typically valued separately, as well.  So, EBITDA is the current state of annual cash flow, before taxes, available to all financial stakeholders in the enterprise. The rate by which that annual cash flow is expected to grow also impacts the projections of future net cash flows.

Second, what is "net present value?"  Since I am valuing this enterprise today, I want to know not just what the aggregate value of all future cash flows is, but what the aggregate value of the present value of each of those future cash flows is.  (I wouldn't agree to pay you a dollar today in exchange for you paying me a dollar in the future, because interest rates are positive -- I would want you to pay me more than a dollar in the future if I paid you a dollar today.)  So, I need to discount each of those projected future cash flows back to today, the valuation date, using the appropriate discount rate, in order to determine what each of those is worth today.  This discount rate is comprised of the "risk-free rate" (in dollars, this is the appropriate term US Treasury Bond yield prevailing in the market) and a "risk premium rate" (added to this risk-free rate) that is a function of the riskiness (potential variability or uncertainty) associated with the cash flow projections.  As the discount rate increases, the present value of any given future cash flow decreases, even as the future value of that cash flow remains unchanged.

In shorthand valuation parlance, the valuation multiple is a function of the expected growth rate in the enterprise's future cash flows and the discount rate, which is itself comprised of both the risk-free rate and the risk-premium rate.  The higher the growth rate, the lower the risk-free rate and the lower the risk premium rate go, the higher the enterprise valuation goes, holding the past year's EBITDA constant.  The lower the growth rate, the higher the risk-free rate and higher the risk premium rate go, the lower the valuation goes, holding the past year's EBITDA constant.  Of course, the higher the past year's EBITDA is the higher the valuation, all else equal, and vice versa.

The enterprise valuation, before any adjustments for required capital expenditures or unique tax attributes, is equal to the product of EBITDA and the enterprise valuation multiple, as illustrated by the following equation:

EV  =  Entreprise Valuation Multiple  X  LTM EBITDA

where:

EV = Enterprise Value

LTM EBITDA = EBITDA generated over the "last twelve months ("LTM")