What is Enterprise Value?
Enterprise Value (EV) is the measure of a company’s total value which includes both equity and debt capital and uses current market valuation for calculation. Another way for calculating the company value is by Book Value and market capitalization but in Book Value the Valuation Of the Company is calculated on the basis of the balance sheet of the company’s financial statements which may differ from the market value, while in Market Capitalization the valuation of the company is calculated by multiplying the number of equity share that is outstanding by the price of the stock. Thus, current market value and debt are not included in both of these methods respectively. Therefore, Enterprise Value is the method to consider the correct and accurate value of the company.
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For calculating company value with Enterprise Value the following formula is used:
EV = Market Capitalization+ Market Value of Debt – Cash and Equivalents.
EV = Equity Stock + Preferred Stock + Market Value of Debt + Minority Interest – Cash and Equivalents
- Market cap means the value of a company calculated by multiplying the current share price by the total outstanding share of the company.
- Equity stock is the stock that shares the ownership of the company through stock and profit-sharing.
- Preferred stock is a combination of features that include both equity and a debt instrument and this holder have a high claim on its share compare to equity shareholder.
- Total debt is the total liability to the company which can be short-term and long-term or other money which are borrowed from banks as lone are considered under total debt.
- Minority Interest is defined as the portion of subsidiaries that are held by the minority shareholders.
- Cash and Investments are highly liquid investments like cash in hand, cash at bank, short-term investment, marketable security, etc. this amount is subtracted from Enterprise Value to reduce the acquiring costs of the company.
Calculation of EV:
XYZ Company Limited
In simple terms, for example, Company A has Rs.60 million in market cap, Rs.20 million in cash, and carries no debt.
Company B, on the other hand, has Rs.60 million in market cap, no cash, and carries Rs.30 million of debt.
Thus, we can analyze that if the investor wants to buy he can go for company A as its value is cheaper and does not consist of any debt.
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Importance of Enterprise Value:
- Enterprise Value is mainly used at the time of acquisition and merger to know the correct value of the company and how much debt it contains can be known
- It represents the economic value of a company.
- Returns from different businesses can be compared to the ones interested in buying controlling stakes.
- For the stock market investors, it is used to neutralize the risks and accordingly compare the returns expected.
- Comparison can be made easy which the help of EV as it takes into consideration only the amount not the structure of the company’s capital.
Drawbacks of Enterprise Value:
- One of the main drawbacks of EV is that if the company is having no debt in its balance sheet but still negative enterprise value can occur. Since EV is greatly influenced by a company’s stock price, if the price falls below cash value, a negative EV can result.
- While calculating EV a company with more debt than cash will have an enterprise value greater than its market capitalization.
- By calculating EV we may not get the accurate amount for capital expenditures. For example, if the current company has spent money on capital expenditure then it will reduce its cash flow which will result in different values.
Thus we can conclude that EV gives us detailed information about the value which helps the investors to take an accurate decision about the company whether to purchase it or to invest in it. As EV takes into consideration both the current value and debt of the company that’s why the complete image of the can be scrutinized by the investors.
Author: Charmi Mehta
About the Author: Charmi Mehta is currently pursuing MBA with a specialization in Finance from the Department of Business Administration, Bhavnagar. Charmi is very much interested to work with data and its analysis and she is also fascinated by the financial market.