Market capitalization (the share price of the company’s stock multiplied by the number of shares) is just one way to estimate the value of a company. Sophisticated investors rely much more on enterprise value, which includes market capitalization along with cash on hand minus short-term and long-term debts.
Gaurav Sharma, Founder of BankersByDay, explains that enterprise value is an approximation used to quickly compare companies, making it easier to see how one is performing within the industry.
To help entrepreneurs and business owners understand how investors use enterprise value to estimate a company’s worth, we’ve outlined how to calculate enterprise value, when to use it, and how to use it in combination with other financial formulas.
The purpose of enterprise value
Unlike market capitalization, enterprise value takes into account a company’s debt and cash reserves, which are two key measures important to determining a company’s takeover price.
Mat Hultquist, CPA and president of The Hultquist Firm, says enterprise value is the cost of buying a company outright, plus the entire debt and minus the cash on the company’s books. Sharma adds that enterprise value “increases the price that you will have to pay by adding debt, and then reduces it to the extent of liquid cash available.”
Experienced investors realize the enterprise value of one company won’t tell them much by itself. The big picture requires comparing the enterprise value of the company being considered for takeover against the enterprise value of each competitor.
Elements of enterprise value
The enterprise value formula is a simple calculation, but you have to understand its components to get the most out of it.
Market capitalization
Market Capitalization = Price per share x Total number of outstanding shares
For example, a company with 20 million outstanding shares selling for $30 per share has a market capitalization of $600 million. Market capitalization is an important component when calculating enterprise value.
Joel Salomon, CFA, FSA, and chief prosperity officer of SaLaurMor, explains that because the current share price is determined by the public market, market capitalization is important when comparing the company to its competitors.
However, experienced investors never rely solely on market capitalization when determining how big a stake to buy in a company. The enterprise value calculation is the cornerstone of their analysis, not least because share prices can go up and down for reasons unrelated to more important metrics.
Total debt
Total debt is the next factor in the equation. This includes the company’s short-term and long-term debt. To determine this number, add the company’s short- and long-term debt together.
Total Debt = Short-term debt + Long-term debt
Cash on hand
The final factor in determining enterprise value is cash on hand. This is money in bank accounts, literal cash in the registers at company stores, and cash equivalents (often called liquid assets) such as mutual funds, bonds, and money market funds that can be easily and quickly converted to cash. This calculation might even include expected payments for goods or services already sold:
Cash on hand = Cash + Cash equivalents
Calculating enterprise value
Once you have all the necessary variables mentioned above, you can determine enterprise value by adding market capitalization and net debt, and then subtracting cash and cash equivalents.
Market Capitalization = Current Stock Price x Outstanding Shares
Net Debt = Long-term Debt + Short-Term Debt
Enterprise Value = Market Capitalization + Net Debt – Cash and Cash Equivalents
To see this in action, let’s consider a company with the following numbers:
Company A
Current price of share: $5
Number of outstanding shares: 3,000
Short-term debt: $2,000
Long-term debt: $3,000
Cash and cash equivalents: $6,000
Enterprise value: $14,000
To determine market capitalization, you multiply the current price of the stock, which is $5, by the number of outstanding shares, which is 3,000, for a total of $15,000. For the net debt, add the short-term and long-term debt ($2,000 and $3,000) to get $5,000.
Now, add the market capitalization ($15,000) to the net debt ($5,000) and subtract the cash and cash equivalents ($6,000) to arrive at the enterprise value: $14,000.
That number on its own may not make much sense until you start comparing it to other companies within the same industry. This helps you gauge where the company stands.
Let’s look at another company’s numbers and see how Company A compares. To simplify things, we went ahead and calculated market capitalization and net debt.
Company B
Market capitalization: $13,000
Net debt: $1,000
Cash and cash equivalents: $5,000
Enterprise value: $9,000
In this example, Company B has a lower enterprise value than company A, but it also has much less debt. A higher enterprise value may not always mean the company is more profitable than one with a lower enterprise value.
When you understand the components that go into enterprise value, you can begin making deductions about the company’s worth. For example, Hultquist says, “Really high debt load is going to be a drag on the company,” it also means “the company with more debt is going to be riskier.”
That being said, two companies could have the same enterprise value and still have drastically different financial makeup. Let’s compare a third company:
Company C
Market capitalization: $7,000
Net debt: $6,000
Cash and cash equivalents: $4,000
Enterprise value: $9,000
Company C has the exact same enterprise value as company B, yet it has much more debt in comparison. Hultquist says you can’t take these numbers at face value, “You have to look at the details.” This is important to note because if you were to buy Company C, you’d be responsible for paying off its large debt load.
Comparables analysis: Enterprise value ratios
Once you determine the enterprise value (EV) of a company, you can delve deeper with a “comparables analysis.” Investors run a comparables analysis to examine ratios, such as EV/sales and EV/EBITDA, that allow them to compare companies in the same industry and growth stage. These ratios are then used to make a relative comparison.
The EV/sales ratio compares the company’s enterprise value to annual sales, or revenue. This calculation (enterprise value divided by sales) is all the rage in today’s bubble market. Many new businesses currently on the market generate little revenue and spend more money than they make.
EV/EBITDA is the other commonly used ratio. It divides enterprise value by EBITDA (earnings before interest, taxes, depreciation, and amortization). Sharma says the ratio removes interest, depreciation, and amortization from the equation, which provides for better comparisons. A low ratio may mean the company is undervalued, while a high one could indicate that it’s overvalued.
Again, you won’t gain much from the ratios of a single company until you compare them with the same ratios of other companies. That deeper comparative analysis will give you a holistic view.
Understanding equity value
In addition to market capitalization and enterprise value, equity value is another term that’s often used in the financial world. Sharma says, “Equity value is the same concept as market cap. It’s just that these terms are not standardized, and there are different levels of depth you can go into when calculating them.”
Market capitalization and equity value both take into account the company’s outstanding shares, but equity value also considers mandatory and optional convertible instruments (debentures and preferred stock) and stock options, which will only be vested if they are profitable, according to Sharma.
When comparing equity value to enterprise value, equity value, like market capitalization, often helps investors make predictions about the company’s value in the future, while enterprise value conveys the company’s current worth.
Whatever calculations you use, the most important thing to remember is that you can’t determine a company’s value in a vacuum. Until you understand all the factors and formulas, you can’t begin to compare companies’ values meaningfully.
For related information regarding enterprises and enterprise resource planning, review our in-depth guide.
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