Enterprise value; Definition, importance, and calculation
What is enterprise value (EV)?
In its simplest form, enterprise value (EV) is the theoretical takeover price of a company. Meaning, it is the company’s market value, which you need to pay for acquiring it.
A company’s enterprise value is seen as a comprehensive alternative to its market cap and is mostly used in Mergers and acquisitions, as it gives an estimate of how much the buying entity must pay to take over the company. Enterprise value is a better alternative to market cap since it considers both the debt and the cash on the company’s balance sheet.
This is is how you can calculate enterprise value –
Enterprise Value = (Market cap + debt) – cash
Market capitalization (also known as equity value) is the company’s perceived value by the stock market participants. It is calculated by multiplying the company’s stock price by the number of outstanding shares (shares that are available to the public to trade). And that is basically the total value of all the shareholder’s stakes in the company. So if you want to take over the whole company, that’s what you need to buy first.
Second, comes debt. Once you acquire the company, whatever debt the company has, is your responsibility, and would need to pay that off eventually. So that’s is added to the total cost of acquisition.
The next is cash. And that’s deducted from the total cost. Because whatever cash the company has, it’s yours once you take over the company. That cash can be used to repay some of the debt. So it makes sense to deduct it from the total amount you need to pay for the company.
Components of Enterprise value
Market capitalization can be calculated by multiplying the number of outstanding shares by the share price.
For example, if a company has 50 million shares outstanding, and the share price is $100, then the market cap is $5 billion (50 million shares x $100 per share).
Preferred stock is technically equity. But depending on how it is issued it can also act as debt. For example, a preferred stock that must be redeemed at a future date at a certain price is, by all definitions, debt. And in most instances, preferred stockholders are entitled to a larger fixed dividend compared to common stockholders. They also have a higher priority in asset and earnings claims.
Since the preferred stock has a larger claim on the business, the holders must be repaid in a takeover. So similar to debt, it is taken into account when calculating the enterprise value.
Acquiring a company equals, acquiring everything the company owns and owes.
This includes both long-term and short-term debt. So once you’ve taken over a company, it is your responsibility to pay it back to the creditors. Let’s say a company is worth $50 million, and the company has $10 million in debt. So even after you pay $50 million to buy the company, you still need to pay off the debt, which is an additional $10 million. So your total cost is $60 million.
This is the reason debt is added to the enterprise value of a company.
When you acquire a company, the cash is yours to use, just like the debt is yours to pay.
This includes cash in the bank and other cash equivalents, like short-term debt and marketable securities. Cash reduces the acquisition price. As cash is the most liquid asset the company owns, it is assumed that the buyer will use it immediately to pay off a portion of the debt. So cash is deducted from the enterprise value.
What is the use of Enterprise value?
Enterprise value in investing
Enterprise value is used by investors to value a company. Especially investors who follow the value investing strategy, often use enterprise value as a metric to compare companies in the same industry.
Investors also use the EV/EBITDA also known as the EV multiple, in valuing a company. EBITDA stands for earnings before interest, tax, depreciation, and amortization. EV multiple is often used as an alternative to the traditional P/E ratio.
Unlike the P/E ratio, EV/EBITDA takes into account debt and the cash the company has.
Enterprise value in Mergers and Acquisitions
Enterprise value is very useful in mergers and acquisitions. In fact, enterprise value is considered a more accurate measure of the value of a company compared to its market cap. The reason being, enterprise value takes debt into account, which must be paid by the buyer when acquiring a company.
Because two similar companies with the same market cap can have different enterprise values.
If a company has a market capitalization of $100 million and $10 million in cash and no debt, its enterprise value will be $90 million ($100 million + zero debt – $10 million cash).
Meanwhile, an identical company that has a market cap of $100 million and $20 million in debt, and $5 million in cash, will have a market cap of $115 million ($100 million + $20 million – $5 million).
In this scenario, we can see that the first company is cheaper to acquire, since it does not have any debt to pay off, and they have spare cash.
Consider the examples of Advanced Micro Devices (AMD) American Airlines (AAL). AMD has an enterprise value of $130 billion which is less than its market cap ($134 billion). Whereas in the case of AAL, the company has a market cap of $12.8 billion and an enterprise value of $43.19 billion – almost 4x its market cap!
The reason is American airlines have a lot of debt and as a result, you need to pay a lot more than its market value in order to acquire the company. AMD, however, has very little debt, and as a result, has an acquisition price (enterprise value) that is less than its market cap.
And as you can see, enterprise values can also be used to compare companies with different capital structures. Capital structure is the combination of capital that is used to fund a company. That includes shareholder equity, debt, and preferred stock. And a difference in capital structures can affect the enterprise value.
There are some downsides to using enterprise value in the valuation of a company. When using enterprise value, a company with a relatively high amount of debt might be seen as less of a prospect than a company with less debt. What many fail to realize is that their competitors also have similar levels of debt.
A better way to use enterprise value when valuing a company is to look at other companies in the same industry.
How can you use Enterprise value?
Even if you don’t want to take over a company, you can use EV multiple in valuing companies. Remember, it is a more accurate representation of what a particular company is worth. And you can use it to identify whether the company is overvalued or undervalued.
A low ratio relative to peers might indicate that the company might be undervalued, and a higher ratio means the company might be overvalued. Then again, companies in high-growth industries tend to have a higher ratio compared to companies in slow-growth industries.
Ideally, when using EV multiple, you should compare the ratio of a company with similar companies in the same industry.
- Enterprise value is the total takeover price of the company. It includes the equity and debt capital of the company.
- It is mostly used in Mergers and acquisitions as it provides an accurate cost of acquiring a company.
- Enterprise value can also be used by individual investors in comparing companies within an industry.
To learn more about valuing companies, check out our bestselling book The 8-Step Beginner’s Guide to Value Investing.
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