What is enterprise value (EV)?
Investing in a company and need to know the true market value of the business? The enterprise value formula can help you understand the total value of a business in a more holistic way than is allowed by market capitalisation figures. Find out everything you need to know about enterprise value calculations, right here. First up: what is enterprise value?
Understanding enterprise value
Enterprise value is a measure of a business’s total value. Rather than just looking at equity value, enterprise value also takes market value into consideration, which means that all ownership interests and asset claims are included in the valuation, i.e. short/long-term debt and cash on the company balance sheet. Essentially, enterprise value is the theoretical takeover price of a company, equating to the amount it would cost to buy every share of a business’s common stock, preferred stock, and outstanding debt.
How to calculate EV
If you want to know how to calculate EV, you’ll need to know a couple of important figures. Here’s the enterprise value formula you can use for your calculation:
Enterprise Value = Market Capitalisation + Total Debt – Cash and Cash Equivalents
Now, let’s look at these components in a bit more detail:
Market Capitalisation – Also referred to as “market cap”, market capitalisation is equal to the current stock price of the company multiplied by the number of outstanding shares.
Total Debt – Total debt is the sum of all the company’s short and long-term debt.
Cash and Cash Equivalents – Including cash, foreign currencies, and cash equivalents (i.e. bank accounts, treasury bills, short-term government bonds, etc.), cash and cash equivalents are equal to the liquid assets of the company but may not include marketable securities.
For a little more insight into the enterprise value formula, and why it may be superior to market capitalisation, let’s see an example. Imagine that Company A has $500,000 in market capitalisation, cash and cash equivalents of $10,000, and a total debt of $100,000. Company B, on the other hand, has $500,000 in market capitalisation, $50,000 in cash/cash equivalents, but no debt.
While the two companies have the same figure for market capitalisation, their enterprise values are markedly different ($590,000 and $450,000, respectively). As you can see, Company B is substantially cheaper to buy because there aren’t any debts that need to be paid off.
When should you use the enterprise value formula?
Enterprise value gives you the prospective takeover price of a company. It’s seen as much more accurate than simple market capitalisation because it includes debt in its valuation framework. As such, the enterprise value calculation is especially useful for investors, while it may also be useful for comparing businesses with different capital structures. It’s also important to note that enterprise value is used as a basis for many different financial metrics and ratios, including EV/EBITDA, EV/EBIT, and EV/Sales. These types of ratios are often used to compare the financial performance of a company, which means that they’re often helpful for analysts.
Limitations of the enterprise value calculation
Before using the enterprise value formula, you should be aware of some of the drawbacks. Because enterprise value includes total debt, you’ll need to consider the way that this debt has been used by the company. In capital-intensive industries, for example, businesses typically shoulder a significant level of debt. However, this debt is used to spur growth (funding the purchase of equipment, making investments, and so forth). So, while the enterprise value calculation would be skewed against these companies in favour of businesses in low/zero debt industries, you may be missing the bigger picture by relying solely on enterprise value.
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