About valuation multiples:
"...an EV/Net Income multiple is meaningless because the numerator applies to shareholders and creditors, but the denominator accrues only to shareholders. Similarly, an equity value/EBITDA multiple is meaningless because the numerator applies only to shareholders, while the denominator accrues to all holders of capital. With this understanding of the relationship between numerator and denominator, we can invent virtually any multiple we like to value a business, so long as the multiple is, of course, relevant to that business."
I don't understand why Net income applies only to shareholders & not debt holders. Can someone shed some more light on valuation multiples in general, & specifically this example?
Net Income is after interest expenses and therefore is only applicable to shareholders since creditors only have claim to predetermined levels of interest expenses. We know that EV=market cap + debt + minority interest + preferred shareholders - cash and cash equivalents. Hence EV involves the value of equity capital and value of debt capital. This is why EV/Net Income is not a valid multiple. EBITDA, by definition, includes the value of pending interest expenses and so is applicable to both shareholders and creditors. So EV/EBITDA is a valid multiple. Knowing these definitions and the formulae for the income statement and EV, to have a valid multiple we must maintain consistency. Hope this helps and if you need any follow up clarification don't hesitate to ask.
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