Enterprise value is most commonly used as a more comprehensive alternative to equity market capitalization. Market capitalization (MCap) is one of the most important components of valuation which is usually employed for valuing the stocks of a company. MCap can be calculated as the share price multiplied by the number of outstanding shares of a company. As such, when compared to market capitalization, Enterprise Value can be defined as the modification of market cap that includes debt and cash for valuing a company. Therefore, apart from market capitalization, EV also includes the debts on a company, both short and long term as well as any cash on the company’s balance sheet. It is also known as Total Enterprise Value (TEV) or Firm Value (FV) and can be considered a more comprehensive and accurate method of measuring a company’s total value. Putting it down in simple words, it is basically the amount anyone should pay in order to buy a given company outrightly or for any potential takeover.
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Going into the formula,
EV = (Market Capitalization + Debt + Minority Interest + Preferred shares) – (Total cash + cash equivalents)
wherein,
Market capitalization = value of the common shares of the company
Preferred shares = If they are redeemable then they are treated as debt
Debt = All-inclusive of bank loans, bonds which are to be dealt with by the acquirer
Minority Interest = It is defined as the portion of subsidiaries that are held by the minority shareholders.
Cash and Investments = Highly liquid investments, cash in hand, cash at the bank are considered
The presence of debts or assets heavily influences the Enterprise Value of a company. Since the acquirer of the company is now liable for the debts of the company, therefore, the increased debts will also increase the cost of purchasing. As such the debts are added in the final EV, similarly the assets like cash are subtracted from the final EV. The acquisition of assets (through cash of issue of shares) increases the EV, even if the assets are not productive, whereas, a reduction in the capital intensity (e.g. working capital), reduces the EV. In case a company holds a huge amount of cash that may not be reflected in the market value of the stock or even the market capitalization, the Enterprise Value of the company can even be negative.
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Multiples of Enterprise Value
An enterprise multiple containing the enterprise value is able to relate a company’s total value (as indicated in the market value of its capital taken from all sources) to the measure of earnings which are generated while in operation, such as earnings before interest, taxes, depreciation, and amortization, commonly abbreviated as (EBITDA).
EBITDA is a representative of how a company is performing financially and in some circumstances is used in place of simple earnings or net income.
By formula,
EBITDA = recurring earnings from continuing operations + interest + taxes + depreciation + amortization
The enterprise value/EBITDA metric is used as a tool to compare a company’s value (debt included) to the company’s cash earnings less non-cash expenses.
Importance of Enterprise Value
Enterprise value is a representative of a company’s worth or the economic value of a company and in a scenario when the company is being bought, it also represents the theoretical takeover price as it includes all the debts and cash which the acquirer will be accounted for in the transaction. The Enterprise Value of a company can be used to compare the companies of different capital structures and even the returns from different businesses to the ones interested in buying controlling stakes. The Enterprise Value also holds an important place for the investors as it can be used to neutralize the risks and thereafter the expected returns can be accordingly compared.
Author: Abhay Kanodia.
About the author: An undergraduate student from the Birla Institute of Technology and Sciences, Pilani(BITS Pilani). Exploring the fields of finance and data analytics and its applications in other different domains.
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