The enterprise value (EV) of an organization measures how the market values it. Analysts invented the phrase “enterprise value” to describe a firm’s overall value as an entity instead of its current market capitalization.
The market capitalization metric represents the value of a public entity as measured by the stock exchange. These numbers express the net market value of all remaining shares. Investors compare the enterprise value to market capitalization when appraising an organization to determine its actual value.
Investors cannot entirely rely on the market cap when making investment decisions about a company because it doesn’t consider critical aspects like its cash reserves and debts. EV is essentially an upgrade of Market capitalization.
What Is Enterprise Value (EV)?
Enterprise value is a metric for a company’s entire worth and is typically used as an upgraded and more complex substitute for market cap. Enterprise value considers a firm’s market cap short- and long-term debt and any other cash on its balance sheet. EV is a standard measure for valuing a firm for a potential takeover.
What are the Components of EV?
The equity value is calculated by multiplying the number of fully diluted outstanding shares by the existing retail price of the stock. Besides outstanding shares, fully diluted comprises in-the-money alternatives, converted securities, and warrants.
If a firm wants to take over another company, it must pay an amount equal to or more than its market cap value to its shareholders, not less. However, this alone is not an accurate indicator of a firm’s actual value. As a result, other aspects determine the actual value of a company.
The total debt is the sum of the contributions made to a company by financial institutions and other creditors. They are interest-bearing obligations that include both micro-and macro debt. When a company is purchased, the amount of debt is adjusted by subtracting cash. If the market value of debt is unknown, you may utilize the book value of debt instead.
Preferred stock is mixed-breed security of debt and equity attributes. These stocks are considered more of a debt, in this scenario, since they give assets and earning claim priority over the common stock and they offer a predetermined dividend. Typically, they must be repaid as debt during acquisition.
Non-Controlling (Minority) Interest
Non-controlling interest is the percentage of a business that a parent firm does not hold. The firm owns more than 50 percent but less than 100 percent of the subsidiary. The subsidiarys’ financial statements are incorporated into the company’s financial performance.
The minority interest is added to enterprise valuation since the holding company has integrated financial statements and that minority interest—the parent company includes 100 percent of the revenues, expenses, and cash flow even though it does not own 100 percent of the business.
Cash and Cash Equivalents
Cash and cash equivalent is the most financial asset on a company’s balance sheet. It includes marketable securities, short-term investments, money market funds, and commercial paper. Deducting this amount from EV reduces the potential firm’s acquisition expenses. It is believed that the buyer will use the money upfront to settle part of the potential acquisition price. You immediately pay a dividend or repay debt.
Formula and Calculation for EV
EV = MC + Total Debt − C
Market capitalization (MC) is the present stock price multiplied by the total outstanding stock shares.
Total debt is the sum of long and short-term debt.
Cash and cash equivalent (C) represent a company’s liquid assets, which may or may not comprise marketable securities.
To evaluate market capitalization, you start by multiplying the total outstanding shares by the present stock price.
Secondly, add up all of the debt on the balance sheet; short-term and long-term debt.
Lastly, sum up the debt and market capitalization and then use the result to subtract any cash and cash equivalents.
What Does Enterprise Value Tell You?
Enterprise value (EV) can help you estimate the expected purchase price of a firm. In various aspects, EV varies from basic market capitalization, so many people regard it as a more precise depiction of a firm’s worth.
When acquiring a company, the buyer must, for instance, pay off the value of the company’s debt. Consequently, enterprise value gives a considerably more realistic acquisition valuation because it incorporates debt in its valuation analysis.
Market capitalization does not accurately represent a company’s value because it omits several critical aspects, such as its debt and cash reserve. On the other hand, enterprise value is essentially a modified but more complex market cap as it considers debt and cash when establishing valuation.
Why Is Cash Deducted From Enterprise Value?
To illustrate why cash is removed from enterprise value, imagine you are a venture capitalist who wants to buy 100% of a publicly listed firm. When you’re preparing your acquisition, you notice that the firm’s market capitalization is $100 million, which means you’ll need $100 million to buy all of its current owners’ shares.
But what if the corporation also has a cash reserve of 40 million? In that case, the true”cost” of acquiring the firm would be merely $60 million because acquiring the company would instantly provide you access to its $40 million in cash.
Why Is Debt Added to Enterprise Value?
Debt is added to enterprise value because it has a greater priority than stock owners on obligations of the business’s assets and value and receives payment first. As a result, the greater a company’s debt balance, the less valuable its activities are.
Higher debt represents an additional expenditure that any potential buyer must pay, resulting in a higher enterprise value. As in our last instance, assume that the company owes $10 million in debt. With that in mind, you now know that, in addition to the $100 million you’ll need to acquire the shares from existing owners, you’ll need an extra $10 million to pay off the company’s debts.
Using these figures, the total worth of your company would be $90 million, which is equal to $100 million in market capitalization plus $10 million in debt minus $20 million in cash.
Why is Enterprise Value Used?
Enterprise Value is widely used for EV/EBIT (enterprise value to earnings before interest and taxes ratio), EV/FCF (Enterprise Value to Free Cash Flow ratio), EV/Sales, or EV/EBITDA (enterprise value to earnings before interest, taxes, depreciation, and amortization ratio) for similar studies such as exchanging comparables.
Other calculations, such as the P/E (Price to earnings) ratio, often do not take cash and loans into account in the same manner as EV does. As a result, two comparable enterprises with the exact market valuation might have two unique enterprise values.
For example, Company Y has a market valuation of $80 million, $20 million in cash, and no debt. On the other hand, Company Z has a market valuation of $80 million but no cash and is in debt for $30 million. In this simple case, you can observe that Company Y is less expensive to purchase because it has no debt to pay off creditors.
Enterprise Value is precious in Mergers and Acquisitions, particularly when controlling corporate governance interests are involved. Furthermore, it is crucial to compare organizations with alternative capital structures since capital structure changes impact a company’s enterprise value.
Limitations Of The Enterprise Value Calculation
Before employing it, it’s important to note that enterprise value calculation has its downsides. Companies in capital-intensive sectors, for instance, generally carry a substantial amount of debt. Since enterprise value comprises total debt, you must analyze how the corporation uses this debt.
This debt, on the other hand, is utilized to stimulate growth. So, while the asset value estimate would be skewed against such businesses in favor of enterprises in low/zero debt industries, focusing exclusively on enterprise value might well be missing the more comprehensive picture.
Any investment, be it in stocks or a specific firm as a whole, will require extensive knowledge of the industry’s fundamentals, as well as comparisons with peers, which can be accomplished with the help of EV calculations. Based on previous and forecast cash flows, the business multiple indicates how costly or inexpensive a company is.
It enables investors to make informed judgments based on their market valuation, debt, and liquidity situation. However, it is essential to consider that business multiples may not always be infallible since a cheaper stock may suffer the brunt of bad market emotions.