You're considering investing in a company, but you want an accurate estimate of its current market value first. The enterprise value formula can provide a more comprehensive understanding of a company's total worth than market capitalization figures. This is because the formula takes a variety of things into account. For private equity investors, the enterprise value is the sum of market capitalization and net debt (debt minus cash). It provides an overview of the costs invested to leverage capital to acquire the targeted company.
What is enterprise value (EV)?
Enterprise Value (EV) quantifies a company's total value. It considers the total market value, not just the equity value, so all ownership rights and asset claims from debt and equity are considered. EV may be thought of as the effective cost of purchasing a corporation or the potential price of a target company (before a takeover premium is applied) (before a takeover premium is considered).
What does EV indicate?
Enterprise value (EV) could be thought to be the hypothetical purchase price if a company were to be acquired. Many consider EV to be a more accurate measure of a company's value than basic market capitalization. The value of a company's debt, for instance, would need to be paid off by the acquiring party. As a result, enterprise value provides a significantly more realistic appraisal for a takeover because it incorporates debt into its calculation.
Why does market capitalization not accurately reflect the value of a company? It omits a number of essential criteria, such as a company's debt and cash reserves. Enterprise value is essentially a modification of market capitalization, as it integrates debt and cash when valuing a company.
How does enterprise value work？
Enterprise value can be used to compare a firm's investment value to its competitors.
Some investors, especially those who subscribe to a value investing mentality, will seek out companies with a high cash flow to enterprise value ratio. Typically, businesses that fit within this category require minimal extra reinvestment.
However, there are disadvantages to adopting enterprise value as the sole metric for a company's valuation. A high level of debt, for instance, might diminish the value of a business, even if the debt is being used wisely.
For example, businesses that require a great deal of equipment are frequently indebted, but so are their competitors. To compare enterprises within the same industry, enterprise value is preferable because their assets should be utilized similarly.
What constituents comprise EV?
Equity Value
Equity value is determined by multiplying the number of fully diluted shares outstanding by the stock's current market price. Fully diluted indicates that it includes in-the-money options, warrants, and convertible securities in addition to the number of outstanding common shares.
If a firm intends to acquire another, it will be required to pay at least the market capitalization value to the target company's shareholders. This is not regarded as an accurate indicator of a company's true value, which is why it is combined with other variables in the EV equation.
Total Debt
The sum that can be considered to be owed, including what the banks and other creditors have contributed, is the total debt. They are interest-bearing liabilities consisting of both short- and long-term debt. Cash is subtracted from the amount of debt because, in theory, the acquirer can use the target company's cash to pay a portion of the assumed debt when a firm is bought. If the market value of the debt is unclear, the debt's book value might be substituted.
Preferred Stock
Preferred stocks are hybrid securities that combine equity and debt characteristics. In this instance, they are viewed more like debt because they pay a fixed dividend amount and prioritize asset and earnings claims more than common stock. In a typical acquisition, they must be repaid similarly to debt.
Non-Controlling (Minority ) Interest
Non-controlling interest is the part of a subsidiary that the parent business does not own (Total debt is the amount that can be deemed to be due, including what banks and other creditors have contributed.). This subsidiary's financial statements are combined with the financial results of the parent firm.
We include this minority interest in the calculation of EV because the parent company's consolidated financial statements include this minority interest. This means that the parent company includes 100 percent of the revenues, expenses, and cash flow in its numbers, despite not owning 100 percent of the business.
By incorporating the minority investment, EV reflects the whole value of the subsidiary.
Cash and Cash Equivalents
The most liquid asset on a company's balance sheet. Short-term investments, marketable securities, commercial paper, and money market funds are examples of cash equivalents. This sum is subtracted from EV since it reduces the target company's acquisition expenses. It is believed that the acquirer will promptly use the cash to settle a portion of the imaginary purchase price. In particular, it would be utilized immediately to pay a dividend or buy back debt.
Why do we use enterprise value?
Enterprise Value is frequently applied to multiples such as EV/EBITDA, EV/EBIT, EV/FCF, and EV/Sales for comparative studies such as trading comps. Unlike other formulae, such as the P/E ratio, EV typically considers cash and debt. Therefore, two similar companies with the same market capitalization may have distinct enterprise values.
For example, Company A has a market capitalization of $60 million, $20 million in cash, and no debt. On the other hand, Company B has a market capitalization of $60 million but no cash and $30 million in debt. In this simple case, it is evident that Company A is less expensive to acquire because it has no debt to pay off creditors.
Enterprise Value is extremely valuable in Mergers and Acquisitions, particularly when controlling ownership interests are involved. Additionally, it is useful for comparing organizations with different capital structures, as a change in capital structure affects enterprise value.
If you want to calculate EV, you'll need to be familiar with a few key numbers. Here is the formula you can use to calculate enterprise value:
Enterprise Value = Market Capitalisation + Total Debt – Cash and Cash Equivalents
Now, let's examine these components in greater depth:
Market Capitalization - Also known as "market cap," market capitalization equals the current stock price multiplied by the number of outstanding shares.
Total Debt — Total debt is the sum of both short-term and long-term debt.
Cash and Cash Equivalents — Including cash, foreign currencies, and cash equivalents (e.g., bank accounts, treasury bills, short-term government bonds, etc.), cash and cash equivalents equal the company's liquid assets, excluding marketable securities.
Let's examine an example to better understand the enterprise value formula and why it may be preferable to market capitalization. Imagine that Company A has a market capitalization of $500,000, $10,000 in cash and cash equivalents, and total debt of $100,000. In contrast, Company B has a market capitalization of $500,000, $50,000 in cash and cash equivalents, and no debt.
Although these companies have the same market capitalization, their enterprise valuations are significantly different ($590,000 against $450,000, respectively). As can be seen, Company B is far less expensive to acquire because it has no outstanding debts.
When should the enterprise value formula be used?
Enterprise value is the potential acquisition price of a corporation, and it is considered to be far more accurate than simple market capitalization because its valuation framework includes debt. As a result, the enterprise value calculation is particularly valuable for investors, and it may also be used to compare organizations with different capital structures. It is also essential to note that enterprise value serves as the foundation for other financial indicators and ratios, such as EV/EBITDA, EV/EBIT, and EV/Sales. These ratios are frequently employed to compare a company's financial performance, making them useful for analysts.
Five methods to employ enterprise value
Enterprise Value, or EV, can be useful when evaluating a company's value, and it becomes much more valuable when compared with other metrics. Here are five methods to utilize an EV calculation by comparing it to other business valuation numbers:
1. Compare the EV to the book value. To establish the book value of a corporation, you measure each asset individually as opposed to considering a flat sum. Comparing book value to enterprise value can provide a more nuanced assessment of a company's financial health.
2. Compare EBIT to EV. Comparing enterprise value to earnings before interest and taxes (abbreviated as EBIT) reveals how well a company's stock prices, debts, and cash reserves are performing in relation to its profits. This comparison is denoted as EV/EBIT.
3. Compare EV to EBITDA. Similarly to an EV to EBIT ratio, EV/EBITDA analyzes a company's enterprise value and earnings. EBITDA denotes earnings prior to interest, taxes, depreciation, and amortization. In this instance, interest and taxes, as well as depreciation and amortization, are subtracted from earnings.
4. Compare EVs to sales. The EV/sales ratio allows you to compare a firm's valuation to its sales figures. In general, you can anticipate a favorable EV/sales ratio if a company's sales are doing well, its assets are rising, its debts are under control, and its cash reserves are abundant.
5. Compare EV to the P/E ratio. The price-to-earnings (PE) ratio or P/E ratio compares the price of a stock to its earnings. Taking this into consideration might provide a more comprehensive view of a company's market capitalization and, thus, its enterprise value as well.
How do you evaluate acquisition offers utilizing enterprise value?
Here is where things become intriguing. If you are assessing many acquisition proposals and the offers are for stock rather than cash, you must compare the value of the stock offers to each possible buyer's enterprise value. Specifically, if a potential acquirer had a large amount of debt and little cash on its balance sheet, this would enhance the enterprise value. In addition, because some industries are more capital-intensive than others, firms in these industries tend to be highly indebted.
If the acquirer attempts to utilize its share price at face value in its takeover offer, you must fight back and demand more shares, or shares plus cash, in order to achieve an agreement based on the buyer's enterprise value.
This becomes more significant if the acquiring business has a market capitalization of $300 million to $2 billion and its shares are infrequently traded. Such shares are less liquid; you may not be able to sell them as readily or at the expected price as you may with shares of a larger corporation. If a company is being bought and cannot immediately sell a stock, the financial strength of the acquiring company should be relevant, but enterprise value does not convey this.
Notably, if the purchased company continues to exist as a separate legal entity, it does not share liability for the debt. The entire corporation owes the debt. Enter the transaction only if you are certain that the debt can be paid. Before signing a contract, you should conduct a scenario analysis with your financial and legal consultants. Obviously, each circumstance is unique.
P/E ratio vs. EV
The price-to-earnings ratio (P/E ratio) is a valuation statistic that compares a company's current share price to its earnings per share (EPS). Sometimes, the price-to-earnings ratio is referred to as the price multiple or the earnings multiple. The P/E ratio does not take into account the amount of debt on a company's balance sheet.
Nevertheless, EV incorporates debt when evaluating a firm and is frequently used in conjunction with the P/E ratio to achieve a holistic valuation.
Enterprise value is advantageous because it reveals the underlying value of a business based on how it has funded its operations throughout time. When comparing GM (NYSE: GM) and Ford (NYSE: F) market caps of $71 billion and $51 billion, respectively, to Tesla's $730 billion, there appears to be an enormous disparity between the valuations of these U.S. automakers, especially given that Tesla sells far fewer vehicles than its two older competitors. However, when GM and Ford's enormous debt is considered, it becomes apparent that the automakers are not as modest as they initially look.
Limitations of using enterprise value
When evaluating a decent stock to purchase, EV is most effective when comparing companies at comparable stages of the business cycle. GM and Ford are both value stocks, and enterprise value should be used to determine which is the superior investment.
However, when comparing a young firm that is still in growth mode, EV will be of limited help in judging how "cheap" it is relative to its older rivals, as young companies tend to have stronger growth and significantly less debt.
Also challenging for the EV technique is comparing organizations from two distinct industries. For instance, a software corporation may not need to incur debt for the acquisition of property and equipment. In contrast, an energy company's property and equipment costs are typically quite substantial. Thus, debt funding is frequently required while formulating a growth strategy.
Conclusion
Any type of investment, whether in stocks or a company as a whole, requires extensive information on the firm's fundamentals and its comparison to its peers, and this can be accomplished with the use of EV calculations. The enterprise multiple indicates how expensive or inexpensive a stock is based on its historical and anticipated cash flows. It aids the investor in making informed decisions based on the company's market capitalization, debt, and cash situation. However, it is important to note that enterprise multiples are not always infallible, as a stock with a lower price may suffer from unfavorable market sentiment.
Frequently asked questions (FAQs)
Can enterprise value be negative?
A company's enterprise value might be negative if its debt and/or cash exceed its market capitalization. If debt were greater than market capitalization, the company would appear highly leveraged and a high-risk investment. In contrast, if cash exceeded market capitalization and debt, investors would take notice.
How does enterprise value compare to equity value or market capitalization?
Debt holders would be interested in enterprise value because its calculation includes debt and cash, whereas only shareholders would be interested in equity value. Equity value, also known as market capitalization for publicly listed corporations, is calculated by multiplying the number of outstanding shares by the price per share.
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