Calculating the market capitalisation of a company is frequently used to determine the size of a company in the market. Enterprise Value helps calculate a company’s total value. It helps investors determine the true value of a business and compare it with other firms that have similar capital structures in the same industry. Additionally, it can show a company’s overall financial position compared to its competitors.
This article breaks down the components of Enterprise Value, its importance, and formula and its uses, applications and limitations. Read on!
As the name suggests, Enterprise Value (EV) is the measure of the total value of a company in terms of finance. The value includes the market capitalisation of a company, short-term and long-term debt and cash on the company’s balance sheet.
Additionally, the calculation method checks the entire market value of a company rather than just the equity value and, thus, includes all ownership interest and asset claims.
The major components that make up Enterprise Value (EV) are:
Total debt is the interest-bearing liability comprising short-term and long-term debt. This contribution is made by banks and other creditors.
Cash and cash equivalents are the most liquid assets in a company’s balance sheet. Some examples are short-term investments, commercial paper, marketable securities and money market funds.
The equity value of a company is determined by multiplying the value of its fully diluted shares outstanding with the current stock market price. Here, fully diluted shares consist of convertible securities and warrants besides basic outstanding shares.
Preferred stocks are hybrid securities having features of both equity and debt. However, they are mostly treated like debt, primarily due to the fact that they pay a fixed amount of dividends.
The financial statement of minority interest is consolidated with the parent company’s financial report. However, this part of the subsidiary is not owned by the parent company.
Here are some points that depict the importance of Enterprise Value (EV):
The simplified Enterprise Value formula is as follows:
Enterprise Value (EV) = Market Capitalisation + Market Value of Debt – Cash and Cash Equivalents
The extended firm value formula is:
Enterprise Value (EV) = Common Shares + Preferred Shares + Market Value of Debt + Minority Interest – Cash and Cash Equivalents
The market capitalisation value of a company can be derived from its own assets. Here, value means the current or market value of the company, which also combines liability and equity.
To calculate market capitalisation, multiply the outstanding shares by the current stock price. Then, add the total debt value, which includes both short-term and long-term debt. Lastly, subtract any cash and cash equivalents from the total.
For example, let us assume XYZ Ltd. has the following financial insights about MNO Corp.:
Common Stocks = Rs.2,00,000
Preference Stocks = Rs.5,50,000
Minority Interest = Rs.1,00,000
Market value of debt = Rs.1,50,000
Cash and cash equivalents = Rs.3,00,000
On the basis of the data given above, the Enterprise Valuation of MNO Corp. would be:
EV = Common Stock + Preference Stock + Minority Interest + Market Value of Debt – Cash and Cash Equivalents
= Rs.(200000 + 550000 + 100000 + 150000 – 300000) = Rs.7,00,000
Hence to acquire MNO Corp., XYZ Ltd. will have to pay Rs.7,00,000.
Calculating the Enterprise Value is a great way to know the takeover price of a business. It can also determine the potential risks of an entity if it has primarily funded its operations with debt. In addition, it also compares its indebtedness relative to cash on hand with other entities of the same industry.
While determining the profitability of a firm, enterprise value can show a firm’s ability to generate earnings in relation to assets and liabilities. This calculation is useful for investors or for comparing businesses with different capital structures.
However, to do so, it uses various financial metrics and ratios such as EV/EBIT, EV/EBITDA and EV/Sales. Additionally, these are also helpful for analysts as they use them to compare the financial performance of a company.
Enterprise value is applied to understand the value of investing in a company in comparison to its competitors.
Some investors, particularly those with a value investing philosophy, will invest in companies generating a lot of cash with respect to their enterprise value. Businesses that fall into this category will require a little additional reinvestment. However, using the enterprise value method as the only way of valuing a company can have various downsides.
For instance, a high amount of debt can make a business less valuable, even if that debt is being used appropriately. Moreover, businesses with high requirements for equipment carry a lot of debt along with their competitors. Hence, it is best to compare businesses of the same industry since they have the same asset value.
The main limitation while calculating the enterprise value appears during the comparison of dissimilar companies.
Enterprise value quantifies the takeover cost of a company rather than simplifying its value in terms of market capitalisation. For instance, if one company has significant debt and another company with the same market capital has cash reserves, then the second one would cost less to acquire.
Thus, enterprise value is more useful when comparing companies at a similar growth stage.
Secondly, while comparing a young company with an older one, an enterprise value has limited usefulness in determining the takeover price. It is difficult to calculate the takeover price of a young company owing to its growth trajectory and less amount of debt.
Lastly, it is difficult to use the enterprise value method to compare companies from two different industries. For instance, the purchase of property and equipment of a software company needs little debt financing. On the contrary, the cost of property and equipment of an energy company tends to be very high. Thus, debt financing becomes necessary while estimating the growth strategy.
Enterprise value is a key component in analysing a company’s fundamentals and helping to compare it with potential competitors. It helps an investor understand whether a company is undervalued by focusing on the entire picture instead of just calculating the market capitalisation.
Enterprise value calculation includes equity, debt, cash and cash equivalents of a company. Hence, enterprise value has more preference than market value as it can provide a more accurate valuation of a company.
Ans: If a company’s EV/EBITDA value is below 10, it is termed as a good or healthy enterprise value. Here, EV calculates the total value of a company, whereas EBITDA measures a company’s overall financial profitability and performance.
Ans: Enterprise Value helps in assessing the total value of a company. In contrast, the Market Value assesses the value of the company’s share on the stock market. Moreover, Enterprise Value is important in selecting stocks if you are conducting investment research for yourself. Similarly, a Market Capitalisation Value is an effective way to manage portfolio risk in case of investors.
Ans: Enterprise value is a metric defining the prospective cost of acquiring a business. The cash on hand acquired by the business would effectively go to the new owner, who lowers the relative cost to obtain it.
Ans: If an Enterprise Value becomes negative, it can repurchase all its outstanding shares in the market. Moreover, a negative Enterprise Value holds a strong net cash position with more cash and cash equivalents to meet all debts and liabilities.
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
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