Because EV is a capital structure-neutral metric, it is useful when
comparing companies with diverse capital structures. Price/earnings
ratios, for example, will be significantly more volatile in companies
that are highly leveraged.
Stock market investors use EV/EBITDA to compare returns between
equivalent companies on a risk-adjusted basis. They can then
superimpose their own choice of debt levels. In practice, equity
investors may have difficulty accurately assessing EV if they do not
have access to the market quotations of the company debt. It is not
sufficient to substitute the book value of the debt because a) the
market interest rates may have changed, and b) the market's perception
of the risk of the loan may have changed since the debt was issued.
Remember, the point of EV is to neutralize the different risks, and
costs of different capital structures.
Buyers of controlling interests in a business use EV to compare
returns between businesses, as above. They also use the EV valuation
(or a debt free cash free valuation) to determine how much to pay for
the whole entity (not just the equity). They may want to change the
capital structure once in control.
Technical considerations Data availability
Unlike market capitalization, where both the market price and the
outstanding number of shares in issue are readily available and easy
to find, it is virtually impossible to calculate an EV without making
a number of adjustments to published data, including often subjective
estimations of value:
- The vast majority of corporate debt is not publicly traded. Most
corporate debt is in the form of bank financing, finance leases and
other forms of debt for which there is no market price. * Associates
and minority interests are stated at historical book values in the
accounts, which may be very different from their market values. *
Unfunded pension liabilities rely on a variety of actuarial
assumptions and represent an estimate of the outstanding liability,
not a true “market” value. * Public data for certain key inputs of
EV, such as cash balances, debt levels and provisions are only
published infrequently (often only once a year in the annual report &
accounts of the company). * Published accounts are only disclosed
weeks or months after the year-end date, meaning that the information
disclosed is already out of date.
In practice, EV calculations rely on reasonable estimates of the
market value of these components. For example, in many professional
- Unfunded pension liabilities are valued at face value as set out in
notes to the latest available accounts. * Debt that is not publicly
traded is usually taken at face value, unless the company is highly
geared (in which case a more sophisticated analysis is required). *
Associates & minority interests are usually valued either at book
value or as a multiple of their earnings.
Avoiding temporal mismatches
When using valuation multiples such as EV/EBITDA and EV/EBIT, the
numerator should correspond to the denominator. The EV should,
therefore, correspond to the market value of the assets that were used
to generate the profits in question, excluding assets acquired (and
including assets disposed) during a different financial reporting
period. This requires restating EV for any mergers and acquisitions
(whether paid in cash or equity), significant capital investments or
significant changes in working capital occurring after or during the
reporting period being examined. Ideally, multiples should be
calculated using the market value of the weighted average capital
employed of the company during the comparable financial period.
When calculating multiples over different time periods (e.g. historic
multiples vs forward multiples), EV should be adjusted to reflect the
weighted average invested capital of the company in each period.
In your question, you stated:
The Market Cap is driven by the share price and the share price is
determined by buyers and sellers who have access to data on cash and
debts and factor that into their decision to buy or sell.
Note the first point under
"Technical Considerations" there and you will see that the
"access to data on cash and debts" isn't quite accurate here so that is worth noting. As for alternatives, there are many other price ratios one could use such as price/earnings, price/book value, price/sales and others depending on how one wants to model the company. The better question is what kind of investing strategy is one wanting to use where there are probably hundreds of strategies at least.
Let's take Apple as an example. Back on April 23, 2014 they announced earnings through March 29, 2014 which is nearly a month old when it was announced. Now a month later, one would have to estimate what changes would be made to things there. Thus, getting accurate real-time values isn't realistic. Discounted Cash Flow is another approach one can take of valuing a company in terms of its future earnings computed back to a present day lump sum.