What is Enterprise Value (EV)?

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Definition:

Enterprise value is an expansion of a firm’s market capitalization to include all outstanding debts and account for the company’s liquid assets.

🤔 Understanding enterprise value

A company’s enterprise value is an estimate of what it would cost to purchase a company. It begins with market capitalization (share price times the number of shares), as a measure of purchasing all of the company’s equity. Because all debts would also need to be paid off, the amount of all short and long-term debt is added to the market cap. Finally, any cash and cash equivalents are assumed to transfer with the company ownership. So, the company's cash and the value of its short-term investments are subtracted from the purchase price, seeing as they would offset some of that purchase price.

Example

On February 7, 2020, Walmart had a share price of $116.45 and had 2.84 billion shares of the company's stock outstanding. Therefore, the market capitalization of the company was just over $330B. In the company’s last financial disclosure, it reports $7B in short-term debts, $44B in long-term debts, and $8B of cash and cash equivalents. From this information, we can estimate the enterprise value of Walmart.

Enterprise value = $330B + $51B – $8B = $373B

Takeaway

Enterprise value is sort of like the total cost of a fixer-upper…

The broken kitchen counters need to be replaced and the bathroom probably needs to be gutted, and that’s after you buy the place. But once your name is on the mortgage, you get to keep anything the previous owner left, like a comfy mattress in the bedroom or the kitchen appliances. Similarly, when you purchase a company, you’ll have to pay off any outstanding debts, but all cash and cash equivalents are transferred over to you.

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Why is enterprise value important?

A company’s enterprise value (EV) is typically considered a more complete picture of a company’s total value. While other valuation metrics are available, enterprise value can be thought of as the estimated cost to an acquirer. EV is especially important in merger and acquisition situations. In a buyout, the enterprise value approximates what it would take to complete the takeover.

By comparing the enterprise values of two companies, you can see which company is a better buy. For example, imagine two companies with the same market capitalization of $100M. However, company A owes $10M to debtors. Company B is debt-free.

You could acquire either company by purchasing every share in the company, at a cost of $100 million. But, once you own the company, you take control of all the assets and responsibility for all the debts. Therefore, purchasing company A costs an additional $10M of expenses to clear all the claims against the company. Although both companies have the same market value, they have different capital structures. Consequently, company A has a higher theoretical takeover price of $110M rather than $100M.

Likewise, when you take over ownership of a company, you gain access to all of the company assets. So, if company A has $15M of cash on hand and company B has none when you purchase company A, you acquire the $10M in debts, but also the $15M in total cash. That $15M goes right back into your pocket, offsetting part of the $110M you spent clearing all the equity and debt. Now acquiring company A has a total net cost of $95M, making it cheaper to acquire than company B.

How do you calculate the enterprise value of a publicly traded company?

To understand the total value of a publicly traded company, you have to add up all the equity and the debt. Then, you can subtract the liquid assets that would come with the purchase, as it would offset some of the purchase price.

To estimate a company’s enterprise value, you can use the market capitalization and a few numbers reported on its balance sheet. First, multiply the stock price by the number of outstanding shares of common stock to get the market cap. Then, add the short-term and long-term debts. Finally, subtract the cash and cash equivalents. That means the enterprise value calculation looks like this:

In reality, that formula doesn’t exactly capture all of the intricacies involved in computing the enterprise value. Therefore, numbers derived from financial modeling will be a little different.

A more complete calculation of a company’s enterprise value would require adjusting the book value of debt to match the market, and accounting for preferred stocks. You would also need to make a correction for minority interests in subsidiaries.

Because companies make consolidated financial statements, the balance sheet includes information about subsidiaries that might not be wholly owned by the parent company. Therefore, the value of the minority interest equity must be added to the enterprise value as well. Otherwise, there are some ownership interests that have not been fully accounted for.

How do you calculate the enterprise value of a private company?

If the company is not traded on the stock market, the market capitalization is not available. Consequently, to compute the enterprise value of a private company, you would need to use an alternative value to capture the buyout of existing owners.

Information about venture capitalist investments or over-the-counter equity shares might be available to help approximate the market value of the company. You would also need to find a source that explains the company's cash balance and the amount of debt it holds if its statements aren’t public.

What is the difference between enterprise value and equity value?

The market value of a company is its share price. The total value of all shares is called the market capitalization, market cap, or equity value of the company. In general terms, the market cap is what investors are willing to pay for the ownership of the company, given the existing assets, liabilities, and potential future cash flows.

Equity value only accounts for the equity portion of the company’s total price. In familiar terms, it would be what a person would pay you to assume your mortgage and the deed to your home. Enterprise value would be the total sales price for your house, including paying off that mortgage.

What is the enterprise multiple?

The enterprise multiple is a valuation metric that normalizes companies of different sizes so that they can be directly compared. To calculate the enterprise multiple, you simply divide the company's enterprise value (EV) by its earnings rate. Most analysts use the earnings before interest, taxes, depreciation, and amortization (EBITDA).

For example, suppose a company had a market cap of $80M, $20M in debts, and no liquid assets. Then its enterprise value would be $100M. Also, suppose this company had $10M in EBITDA from its core business operations last year. In this case, the company’s enterprise value is 10 times its earnings. We would say its enterprise multiple is 10x.

Is higher or lower enterprise value better?

When looking at the enterprise value (EV) of a company, bigger is not always better. Two companies with the same EV can have very different earnings, growth potential, and debt loads. One might be a rising star while the other is on the verge of bankruptcy.

Remember that EV is basically the purchase price of a company. Just like house shopping, just because one house is more expensive doesn’t mean that it is better. And just because something is cheaper does not mean it is a better deal.

The enterprise multiple is a better indicator of value. It considers the company’s debt as well as its earning power. A high EV/EBITDA ratio could signal that the company is overleveraged or overvalued in the market. Such companies might be too expensive to acquire relative to the revenue they generate. A smaller multiple tends to be a better buy.

What is the difference between the enterprise multiple and the earnings ratio?

The earnings multiple and enterprise multiple are both value metrics that can be used to compare companies.

An earnings ratio is calculated by dividing the company’s market capitalization by its total net earnings. Equivalently, it is the share price divided by the earnings per share (EPS). It is often called the price-to-earnings ratio (P/E ratio).

Earnings multiple = market cap / earnings

Whereas, the enterprise multiple includes the company’s net debt (debt minus liquid assets) in the calculation. The enterprise ratio can be expressed like this:

Therefore, the earnings ratio only looks at the value of the equity in the firm. It tries to identify whether or not a company’s share price is properly valued relative to its earnings. The enterprise ratio is a broader look at the value of the firm, including the company’s debt position.

What are the limitations of using enterprise value?

No individual metric paints a complete picture of a company. The enterprise value (EV) is just one way to understand what a company is worth. That information may help you decide if you think the company is one you want to invest in, given the asking price.

But there are components of the EV calculation that may be confusing or may not represent the company’s full story. In theory, the equity portion of the equation allows the market to price in growth potential and other unknowns. However, there is no guarantee that the market is pricing the company correctly. Likewise, not all debts are equal. When including debts in the valuation, it might be difficult to assess what resolving those debts might actually cost.

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