Once you start delving deeper into valuation and especially in the premise of mergers and acquisitions, you notice that Enterprise Value is an essential term in this field.
A company’s value consists of its owned assets, but in reality, obtaining their market value can be tedious and resource-intensive. Following the accounting equation, we can value these by the shareholder’s equity and liabilities, which the company used to finance its assets. By considering the market value of the firm’s equity and liabilities, we can derive the current market value of the business.
It helps investment analysts to evaluate potential new investment opportunities. The EV metric is vital because it’s not affected by capital structure, but only by the core operations of the business.
To move away from the Market Value of Equity of the business and over to Enterprise Value, we remove the non-core business assets like cash and short-term investments and add all liabilities, which are the items that represent all other investors.
Enterprise Value in a Nutshell
To put it simply, Enterprise Value (EV) is a modification of market capitalization (market cap) that includes debt and cash. It is a useful metric when we perform company valuations. The metric is also known as Total Enterprise Value and Total Firm Value.
Enterprise Value tells us the worth of the company, which is a theoretical price for taking over the business, before considering the takeover premium. It accounts for the debt and cash balances the acquirer will also assume. The metric looks at total market value and is useful to compare companies with different capital structures. That way, EV considers all shareholder interests and claims on assets, both from debt and equity.
EV helps capture the total value of the business and is a more accurate and comprehensive representation. It is the minimum an investor would pay to acquire a company.
The metric helps investors to make appropriate decisions considering the market capitalization, together with the debt and cash positions of the company. It is a more accurate interpretation of market cap.
Enterprise Value serves a two-fold purpose:
- To calculate the cost to acquire the whole business;
- A capital neutral valuation to compare companies.
When we evaluate a business with its EV, it is crucial to pay attention to how the company uses its debt and liabilities. Some firms within capital intensive industries carry lots of debt to facilitate growth. This will impact the Enterprise Value and make comparisons of such firms to ones within other industries highly inaccurate. Therefore, it’s usually a good idea to use EV to compare companies within the same industry.
Enterprise Value Calculation
We calculate the metric with the following formula:
Market Capitalization is the value of the common shares of the company. We derive the Market Value of Equity by multiplying the total outstanding shares of the company by the current market price of the stock. If you plan to acquire a company, you need to pay at least the market cap value. This alone is not an accurate measure of the total cost of the business, so Enterprise Value considers other components as well.
Preferred stock displays the features of both debt and equity. Preferred shares have a higher priority in asset claims than common stock, and they pay out a fixed dividend. We treat these as debt, as they usually have to be repaid in an acquisition.
Debt includes all liabilities of the company. These are interest-bearing loans and borrowings that represent the contribution to the business by banks and creditors. An acquirer assumes liability for all debts of the company. Therefore, debt increases the purchasing cost, and we add to the Enterprise Value calculation. By including debt, which has to be paid by the acquirer, the EV provides a more accurate takeover value. If there’s no way to determine the market value of debt, we can use the book value instead. We deduct cash as, in theory, the acquirer can use the company’s money to cover a portion of this debt.
NCI (or Minority Interest) represents the portion of subsidiaries that is held by the minority shareholders, meaning the parent entity does not own it. We add it to ensure 100% of the subsidiary value is in EV. That way, the calculation reflects the parent showing 100% of the subsidiary performance in its consolidated financial statements, even if owning less than that.
Cash is the most liquid asset and includes cash on hand and in bank accounts, as well as any highly liquid short-term investments and marketable securities, as we can easily translate these into monetary funds. We deduct cash from the EV calculation, as it reduces the cost of acquisition. The acquirer can use it either to cover the purchase price or to pay out debt and dividends.
Looking at the components of the Enterprise Value equation, we can see that Debt and Cash can have a significant impact on the metric. Two companies might have the same market capitalization, but if one has more cash or debt, they will have different EV’s.
If the company has cash balances exceeding its outstanding debt, then EV will be below the market cap. And, vice versa, if the liabilities exceed the cash balance, the market cap will be higher than the Enterprise Value. EV can also, in theory, be below zero if the business has retained abnormal amounts of cash.
EV Multiples and Ratios
We often use the Enterprise Value to calculate various multiple ratios, like EV/EBITDA, EV/EBIT, EV/Sales, EV/FCF. These contribute to great benchmark analysis, as they include the effect of cash and debt, unlike other ratios like the Price/Earnings ratio, for example.
EV/EBITDA is useful when evaluating capital intensive businesses. We can also use this multiple to compare firms with different capital structures and different degrees of financial leverage. When comparing two companies, generally, the one with lower EV/EBITDA multiple is the better investment opportunity. However, EBITDA can become misleading if there are significant capital expenditures. EBITDA gives the most accurate results when CAPEX is close to the depreciation and amortization expenses.
EV ratios give key insights when comparing between companies, even such with significantly different capital structures.
Sample Enterprise Value Calculation
Here’s a simple example of how we might approach calculating and comparing the Enterprise Values of three companies.
Following the formula and explanations outlined above, we can fill in the template and arrive at the EV’s of each entity.
Running the calculation, we arrive at a theoretical acquisition cost of €16 thousand.
For our second and third companies we get, respectively:
It is important to note that Company C has the highest Market Cap (Market Value of Equity) out of the three, more than twenty times over. However, due to a large amount of cash retained within the business, the Enterprise Value is significantly lower, meaning the theoretical cost of acquisition is lower than for Companies A and B because we will get €165 thousand to cover debt and liabilities.
Enterprise Value is one of the critical metrics for investors and analysts. It’s capital neutral and gives us the total value of the company. It is useful to calculate EV ratios, which provide insightful metrics for running comparative analysis on companies.
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The information and views set out in this publication are those of the author(s) and do not necessarily reflect the official opinion of Magnimetrics. Neither Magnimetrics nor any person acting on their behalf may be held responsible for the use which may be made of the information contained herein. The information in this article is for educational purposes only and should not be treated as professional advice. Magnimetrics and the author of this publication accept no responsibility for any damages or losses sustained in the result of using the information presented in the publication.
can you give us a more elaborate Equity valuation of switching or any other company that help to understand and clear the valuation method.
I am not sure I understand your question fully. I have two other posts that are related to Equity value, maybe you can take a look here: