Valuation Multiples Calculation: What Goes in the Numerator and Denominator With One Simple Rule… Question the Other Day… “You’ve said before that if the Numerator of a valuation multiple – Equity Value or Enterprise Value – includes the value of a Balance Sheet item, then you should not include its corresponding income or expenses in the Denominator.” Question the Other Day… “But you subtract Equity Investments when calculating Enterprise Value…

…and then metrics such as EBIT and EBITDA also exclude Net Income from Equity Investments.

So, is this rule correct?” Valuation Multiples – The Rule • SHORT ANSWER: “No, this rule is not quite correct.”

• It’s better to think of it using this logic:

• Numerator of Valuation Multiples: Should be Equity Value or Enterprise Value… sometimes slight variations

• Denominator of Valuation Multiples: Could be almost anything – Revenue, EBIT, EBITDA, Net Income, Free Cash Flow, etc.

• Test: Does the Numerator add or subtract a Balance Sheet line item? Valuation Multiples – The Rule • Test: Does the Numerator add or subtract a Balance Sheet line item?

• If so, then you should not include income or expenses from that item in the Denominator

• Rule: And if the Numerator does not add or subtract a Balance Sheet line item, then you should include the income or expenses from that item in the Denominator

• Implication #1: If Equity Value is the Numerator, the Denominator must be Net Income to Common, or a metric that starts with Net Income to Common, such as Free Cash Flow Valuation Multiples – The Rule • Why: When you calculate Equity Value for a public company, you don’t add or subtract any Balance Sheet line items; it’s just Share Price * Share Count!

• So: You must include everything on the Income Statement – all income and expenses – in Denominators paired with Equity Value

• Implication #2: If Enterprise Value is the Numerator, the Denominator must exclude or be “before” Interest Income, Interest Expense, Other Income, Preferred Dividends, etc.

• Examples: Revenue, EBIT, EBITDA, NOPAT, Unlevered FCF… Valuation Multiples with Enterprise Value • Why: You subtract Cash in the Equity Value → Enterprise Value calculation

• So: You cannot include Interest Income from that Cash in any multiple where the Numerator is Enterprise Value

• Why: You add Debt in the Equity Value → Enterprise Value calculation

• So: You cannot include Interest Expense on that Debt in any multiple where the Numerator is Enterprise Value

• And… going back to that original question about Equity Investments… Valuation Multiples and Equity Investments • Calculation: You subtract Equity Investments in the Equity Value → Enterprise Value calculation

• So: You must exclude income and expenses from those Equity Investments in any multiple where the Numerator is Enterprise Value

• And that’s why metrics that pair with Enterprise Value, such as EBITDA, completely exclude Net Income from Equity Investments

• This Rule: Also works for capitalized operating leases – if you add them to Enterprise Value, you must exclude the lease rental expense in the Denominator and use metrics such as EBITDAR instead Recap and Summary • Numerator of Valuation Multiples: Equity Value or Enterprise Value, with slight variations (capitalized leases)

• Denominator: If Equity Value is the Numerator, the Denominator should be Net Income to Common, or a metric that starts with Net Income to Common (e.g., Free Cash Flow)

• Why: You do not add or subtract any Balance Sheet items to calculate Equity Value, so you include all IS income and expenses

• If Enterprise Value is the Numerator, the Denominator must exclude the income and expenses corresponding to everything added or subtracted in the Equity Value → Enterprise Value calculation Recap and Summary • Why: You add or subtract Non-Core-Business items to calculate Enterprise Value, so exclude Non-Core-Business income and expenses in valuation multiples

• Enterprise Value / EBITDA makes sense – but not Equity Value / Revenue

• Equity Value represents All Assets… so the Denominators of Equity Value-based multiples must include All Income and Expenses

• Enterprise Value represents only Core-Business Assets – so the Denominators of multiples based on it must reflect only Core-Business Income and Expenses