The formula, and the signal it produces#
Enterprise value is market cap plus total debt minus cash — what it would genuinely cost to acquire the business, since a buyer inherits the debt and receives the cash.
Two companies, both at a $500M market cap:
| Company A | Company B | |
|---|---|---|
| Total debt | $200M | $0 |
| Cash | $50M | $100M |
| Enterprise value | $650M | $400M |
A costs $250M more to acquire despite the identical sticker. The standard reading follows immediately: A carries hidden obligations, B has flexibility and stability.
That reading is fine as far as it goes. It just stops one question too early.
The question that comes next#
Why is the cash sitting there?
A company holding a large cash pile has, by definition, decided not to spend it. Not on new capacity, not on acquisitions, not on research, not on returning it to shareholders. That decision is information.
Michael Jensen made this the centre of his 1986 work on the agency costs of free cash flow. His argument: free cash flow — cash beyond what’s needed to fund every project with a positive net present value — is a problem, not an asset. Conflicts between managers and shareholders are most severe precisely in firms with more cash than good opportunities.
The mechanism is uncomfortable and well-evidenced. Paying money out to shareholders reduces the resources under management’s control and forces the firm back to capital markets, where it faces scrutiny. Sitting on the cash avoids both. Jensen argued that managers with large free cash flows and unused borrowing capacity are more likely to undertake value-destroying diversifying acquisitions — buying things to have something to do.
So “strong cash position” splits into two very different companies: one holding cash for a specific coming purpose, and one holding it because nothing in the business justifies deployment.
The same second question applies to debt#
Symmetry matters here. Enterprise value above market cap means net debt, and the reflexive reading is danger.
Also incomplete. Debt is how businesses fund expansion, and cheap debt deployed into projects that out-earn its cost is exactly what good management looks like. A company that borrowed at 4% to build capacity earning 15% has made you money, and its EV looks worse for it.
The useful pairing:
- Net debt funding growth — capacity, acquisitions with a clear rationale, R&D. Read the cash flow statement to see where it went.
- Net debt funding survival — covering operating losses, refinancing prior debt, sustaining a dividend earnings don’t support. Different company entirely, same EV.
- Net cash awaiting deployment — a stated plan, a pending acquisition, a cyclical business holding a buffer.
- Net cash with no plan — the Jensen case.
Four situations, two EV signals. The number sorts them into two boxes; you have to open the box.
What the multiples do and don’t fix#
EV/EBITDA compares enterprise value to earnings before interest, taxes, depreciation and amortisation. Lower suggests undervaluation relative to earnings, higher suggests the opposite. Its real strength is capital-structure neutrality — it lets you compare a debt-heavy company against a debt-free one without the financing distorting the answer, which is exactly where P/E misleads.
EV/Revenue exists for companies that aren’t profitable yet, where EBITDA means nothing. It ignores margins completely, so a dollar of software revenue and a dollar of low-margin distribution revenue look identical to it.
Neither multiple answers the “why” question. A company can show a flattering EV/EBITDA precisely because the market expects its earnings to shrink. The ratio is low because the denominator is about to fall — and screening for the lowest multiple in a sector is a dependable way to assemble a portfolio of businesses in decline.
How to actually use this#
Calculate EV, compare it to market cap, note which direction the gap runs. Then spend the real effort on the follow-up:
For net cash, check whether management has said what it’s for. Buybacks, a named acquisition, a capex programme, a cyclical buffer. Silence across several years alongside a growing pile is the Jensen warning.
For net debt, check the cash flow statement for where the money went and check whether the business generates enough to service it comfortably. Debt funding growth and debt funding survival look identical on the balance sheet and nothing alike in the cash flow statement.
Summary — and what to do about it#
The EV-to-market-cap gap tells you where to look. It does not tell you what you’ll find.
- Calculate enterprise value on anything you’re seriously considering. Market cap + total debt − cash.
- Never read net cash as automatic strength. Ask what the cash is for, and treat prolonged silence as an answer.
- Never read net debt as automatic weakness. Cheap debt funding high-return projects is management doing its job.
- Go to the cash flow statement for the “why”. The balance sheet shows the position; the cash flow statement shows the intent.
- Use EV/EBITDA when debt loads differ. That’s the case where P/E is actively misleading.
- Treat a conspicuously low multiple as a question. The market usually knows something about the denominator.
Two identical market caps, two different bills — and behind each bill, a management decision that the ratio can point at but never explain.
Sources & further reading#
- Michael C. Jensen, “Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers” (SSRN) — the 1986 paper on excess cash as an agency problem.
- Harvard Law School Forum on Corporate Governance, “The Lessons of Michael C. Jensen” — free cash flow and value-destroying acquisitions.
- Winvesta on EV/EBITDA — capital-structure neutrality in practice.
- Eqvista, “Enterprise Value-to-EBITDA” — when the multiple helps and when it misleads.
