EV/Capital Employed Ratio

Shows the value of the company compared to the capital used by the firm where capital used is the summation of total assets and net working capital

The concept of Enterprise Value (EV) is a measure and assessment of a company's total value. The EV calculation includes a company's market capitalization and debt.

The debt includes short-term and long-term obligations and any cash on the company's balance sheet. EV calculation is usually conducted to assess the organization's total worth and is used by a firm trying to acquire another company.

The Enterprise Value is the valuation of the firm as a whole. The main purpose is to assess how the firms value when all the following elements are taken into consideration:

  • Market capitalization
  • Debt
  • Minority interests
  • Preferred Equity
  • Cash & cash equivalents

These elements are considered to conclude how much investment is required to purchase a company.

Enterprise Value (EV)= Market capitalization + debt + minority interests + preferred equity - cash & cash equivalents)

The market capitalization is the shares outstanding times the current price of the shares. The debt includes short and long-term obligations. 

The amount of capital invested in the firm's business used in its operations. It represents how and what the company has invested in its financial resources. This articulation is known as The Capital Employed.

Capital employed can also be the capital resource invested to generate profits. This resultant figure is known as the return on capital employed ratio.

The formula for capital employed has two variations.

Number 1:

Capital employed = Total assets - Current liabilities

And, number 2:

Capital employed = Fixed Assets + Working capital

ROCE ratio measures a company's profitability and efficiency in using its capital. ROCE is a good basic measure of a company's performance. It shows if a company is doing a good job generating profits from the available capital.

The formula for ROCE is:

OI or EBIT/Total Assets - Current Liabilities

The total assets are the total book value of all the organization's tangible and intangible resources.

Current liabilities are debt obligations payable within a year or the operating cycle.

Working capital is the difference between current assets and current liabilities.

Working Capital=Current assets-Current liabilities

Fixed assets are the capital assets that are supposedly acquired for more than one year.

What is EV/Capital Employed Ratio?

Essentially, the EV/Capital Employed ratio is the product of ROCE and the EV multiple. The concept of ROCE and the reason behind its utilization are discussed above.

EBIT, elaborated into Earning Before Interests and Taxes, is an income statement element after deducting COGS and operating expenses from the organization's revenues.

EBIT is an important element of the income statement because it shows the amount remaining to cover its interest expenses and taxes. This amount helps the stakeholders assess the operational capabilities.

So, when we break this formula into bits, it can be written in the following manner:

EV/CE = EBIT/CE x EV/EBIT

The EV to CE ratio shows the value of the company compared to the capital employed by the firm. And as discussed earlier, the capital employed is the summation of fixed assets and working capital or the difference between the total assets and current liabilities.

The first segment of the formula-EBIT/CE shows how many dollars the organization earns for every dollar invested in the business. 

The ROCE is the profitability and returns ratio. Let's say if the ROCE is 0.8, then it means that for every dollar invested, the organization earns a return of $0.8.

The second segment is the formula-EV/EBIT, how much better the company is doing compared to other companies in the industry. Better the ratio, the better the company.

This measure helps the value identify the company's liquidity and ability to satisfy long- and short-term obligations. Also, it facilitates identifying companies with debt baggage and the company's ability to pay with its EBIT.

Illustrations

Assuming a company reported its EBIT to be $20,000. Total assets of $120,000 and current liabilities of $20,000. ROCE calculations are as follows:

ROCE = $20,000/ $120,000 - $20,000

ROCE = 20%

This means the organization generates $2 for every $10 capital employed.

Calculation of EBIT Multiple:

The numerator includes the Enterprise Value(EV). The EV calculation starts with market capitalization, adds debt, and deducts cash and cash equivalents.

Let us say the company has a market capitalization of $300,000, a debt of $35,000, and available cash of $20,000. And, EBIT, same as the above:

= $300,000 + $35,000 - $20,000/ $20,000 = $315,000/ $200,000 = 15.8

EV/Capital Employed = 20% x 15.8 = 3.15

Mr. Hemingway has a chocolate factory that has a PPE of $500,000. The cash and marketable securities stood at $20,000 each. And the accounts receivables were $60,000. 

The current obligations were $50,000, and the long-term obligations on the balance sheet were $250,000. Therefore, the market capitalization was valued at $400,000.

Ascertain the EV/Capital Employed ratio.

The solution should start by taking information from the balance sheet and ascertaining the capital employed first.

Total current assets were $100,000 (cash and marketable securities $40,000 and AR $60,000). The PPE of $500,000. That makes total assets $600,000. 

Total capital employed = Total assets - Current liabilities = $600,000 - $50,000 = $550,000.

Or, 

Total capital employed = Fixed Assets + Working capital = $500,000 + ($100,000 - $50,00) = $550,00.

EV = Market capitalization + debt + minority interest + preferred equity - cash - cash equivalents

EV = $400,000 + $300,000 + $0 + $0 - $20,000 - $20,000 = $660,000

EV/Capital Employed = $660,000/ $550,000 = 1.2

Key Takeaways
  1. Enterprise Value(EV) is a measure of the total value of the organization.
  2. EV includes the market capitalization along with debt, minority interest, and preferred equity, then deducting it with cash and cash equivalents.
  3. The debt includes both short and long-term obligations.
  4. Market capitalization is the outstanding shares times the current price of the shares.
  5. Capital employed is the amount invested for the operations and generating profits. 
  6. EBIT is the Earning Before Interest and Taxes.
  7. Each multiple has its own interpretations.
  8. ROCE shows the metric that measures the efficiency of a company at deploying capital to generate profits.
  9. EV/CE shows the value of a company when compared against the capital employed.
Valuation Modeling Course

Everything You Need To Master Valuation Modeling

To Help You Thrive in the Most Prestigious Jobs on Wall Street.

Learn More

Researched and authored by Farooq Azam Khan, CMA | LinkedIn

Reviewed and edited by Aditya Salunke | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources: