Enterprise value is often used as an alternative to equity market capitalization. It is often part of the discussion of company mergers and acquisitions as a way to understand the value of the companies concerned. Learn more about enterprise value, why it matters to your investments, and how to calculate it.
Definition and Examples of Enterprise Value
Enterprise value is a calculation that theoretically represents the entire cost of a company if a single entity were to take it over. For a publicly traded company, this would mean buying up all of the shares of stock, effectively taking the company private. EV provides a more accurate estimate of takeover cost than market capitalization, because it takes includes a number of other important factors, such as preferred stock, debt (including bank loans and corporate bonds), market capitalization, and excess cash. These numbers are combined to calculate the value of a company’s debt and equity, minus cash that is not used for day-to-day operations. This value can then be compared to the value of other companies in the same industry and used to analyze investments or the value of a merger, trade, or acquisition.
How Do You Calculate Enterprise Value?
You can calculate enterprise value by adding a corporation’s market capitalization, preferred stock, and outstanding debt together and then subtracting the cash and cash equivalents found on the balance sheet. In other words, EV equates to the amount it would cost you to buy every single share of a company’s common stock and preferred stock as well as outstanding debt. You would subtract the cash balance, because once you have acquired complete ownership of the company, the cash becomes yours.
Understanding the Components of Enterprise Value
To understand a company’s enterprise value, you have to understand what each part of the equation represents.
Market Capitalization
Sometimes referred to as “market cap,” market capitalization is the number of shares of common stock multiplied by the current price per share. For example, if a business has 1 million shares of stock outstanding, and the current stock price is $50 per share, the company’s market capitalization is $50 million (1 million shares x $50 per share = $50 million market cap).
Preferred Stock
Although it is technically equity, preferred stock can act as either equity or debt, depending upon the nature of the individual issue. A preferred stock issue that must be redeemed at a certain date at a certain price is, for all intents and purposes, debt. In other cases, preferred stockholders may have the right to receive a fixed dividend, plus they also would share in a portion of the profits. (This type is known as “participating.”) Preferred stock that can be exchanged for the common stock is known as “convertible preferred stock.” Nevertheless, the preferred stock represents a claim on the business that must be factored into enterprise value.
Debt
Once you’ve acquired a business, you’ve also acquired its debt. If you purchased all of the outstanding shares of a business for $10 million (the market capitalization), yet the business had $5 million in debt, you would actually have expended $15 million. The $10 million came out of your pocket today, but you are now also responsible for repaying the $5 million debt out of the cash flow of your new business.
Cash (and Cash Equivalents)
Once you purchase a business, you own whatever cash it has sitting in the bank. In effect, it serves to reduce your acquisition price. For that reason, you would subtract it from the other components when calculating enterprise value.
How Enterprise Value Works
Enterprise value can be used to understand the value of investing in a company as compared to its competitors. Some investors, particularly those who subscribe to a value investing philosophy, will look for companies that generate a lot of cash flow in relation to their enterprise value. Businesses that tend to fall into this category are more likely to require little additional reinvestment. However, there are downsides to using enterprise value as the only way of valuing a company. A high amount of debt, for example, can make a business look less valuable, even when that debt is being used appropriately. Businesses that require a lot of equipment, for example, often carry a lot of debt, but so do their competitors. This is why it is best to use enterprise value to compare businesses within the same industry, since their assets should be used in similar ways.
