Did you know that there are around 58,200 publicly traded companies around the world? How would you know the actual value of such companies? Enterprise value is what companies consult when they want a formula to decide what a publicly traded business is worth. It is the direct valuation metric and frequently the first and sometimes only factor in determining how much to offer for an acquisition, or what you should expect if you sell your company.
This article will cover everything you need to know about ‘Enterprise Value’, its importance and how to calculate EV.
We will look into
- What Is Enterprise Value (EV)?
- Enterprise Value – a Comprehensive Overview
- What Does EV Actually Mean?
- What is the Enterprise Value (EV) Formula and Calculations
- Are There Any Limitations of Enterprise Value?
- How Is Enterprise Value Different From Market Cap?
- How Can You Use Enterprise Value as an Acquirer?
- The Right Way to Leverage Enterprise Value in Evaluating Acquisition Plans
- Why is Enterprise Value Important for Your Business?
- Common Mistakes When Calculating Enterprise Value
- FAQ about Enterprise Value
What Is Enterprise Value (EV)?
Enterprise value, or as the business world calls it, EV, is the complete value of a company, including all financing. This is a combination of the current share price (market capitalisation) and other costs, including any debt that the company has to repay (net debt, or debt minus cash).
When you add those two together, you can start to determine the enterprise value of the company, or what environment you need to be in to buy the company.
Enterprise Value = Market Capitalisation+ Debt - Cash
Key Takeaways
- Enterprise value measures the price you would pay to purchase a business or the cost to acquire, given the company’s capital structure.
- To calculate enterprise value, subtract the current share price for a public company, which is the market capitalisation. From that, add outstanding debt and then subtract available cash.
- It can be used for acquisition prices (Enterprise value) and is known as such. It is also common in many metrics that benchmark the relative performance of different companies, such as valuation multiples.
Enterprise Value – a Comprehensive Overview
It is indeed funny how the EV formula works. Why do we say that?
The first time many people come across the enterprise value formula, their reaction tends to be: “Why would you add a company’s debts to its value and then subtract cash?”
First and foremost, all other things being equal, a company with more cash on hand ought to be worth more than one with less — and it is.
But here is a thing to keep in mind: Enterprise value is a financing calculation, and it is the amount that you would need to pay those who hold a financial interest in the company. What we circle are all equity owners, shareholders and everyone who has lent it money (lenders).
This signifies that if you are buying the company, you have to shell out the stock and then pay down the debt, but you also get any cash reserves of the company itself when you acquire it. So, on account of the fact that you get to keep that cash, it is really like you paid much less when purchasing the company. Which is why you add the debt but subtract the cash when you calculate an acquisition target’s enterprise value.
What Does EV Actually Mean?
More conceptually, enterprise value tells you a whole story if you listen. What would be that story?
It indicates what a real buyer might have to spend to buy the public company outright. In practice, it generally requires a deal premium to EV for an offer to be accepted.
There can be a few reasons for that:
Deal Premium: The company’s board may require a premium over its current share price from its stockholders. Otherwise, there is no point in selling isn’t it?
Supply and Demand: Once an acquiring company begins sucking up stock, the forces of supply and demand typically take hold to push up the share price, all things being equal.
Competitive Bidding: Alternatively, if there is more than one bidder, it might mean a big premium.
What is the Enterprise Value (EV) Formula and Calculations
A business’s enterprise value has nothing to do with its shareholder contribution, that the measure of money given to a business by shareholders. Instead, the ratio considers company debt, which means both short- and long-term, and cash.
Debt and cash are relatively cut and dried, but the concept of market cap could use a bit of explication.
What you can see in the real world is that many businessmen focus on the stock price of a company and whether it has gone up or down. However, the actual value of a share is meaningless when it comes to understanding what a company is worth without other information, notably how many shares are out there.
When you multiply the share price by the number of outstanding shares, you get a company’s market capitalisation. This is a measure that tells you how much the stock value of all its outstanding shares would amount to in dollars.
Let us give you an example. Imagine company ‘A’ operates at $100 per share, while company B does so at $20. But if company ‘A’ has 100 million shares outstanding and company ‘B’ has 500 million shares outstanding, then their market caps are identical: $10 billion. Did you get the idea?
The formula goes as:
100 million shares x $100 = 500 million shares x $20
Are There Any Limitations of Enterprise Value?
Yes, like every other thing in the business world, the latter also comes with limitations.
The primary shortcoming of enterprise value is its inability to compare companies that are not alike. Enterprise value more broadly represents how much it would cost to buy the company outright (takeover cost), and not just its market capitalisation through which it was issued.
Let us justify what we just mentioned. If two companies have the same market cap, but one is sinking under a mountain of debt while the other is sitting on a stash of cash reserves, there is something to be said for buying out the company without all the debt; it would cost less.
However, the tricky part is that EV fails to take into account how companies use the debt they hold. It is true — who wants to own a software company with meaningful debt and next to no sum of cash as an ‘investment option’ over a business that has the same market capitalisation but no leverage, yet the investment call would become more grey when both are in different industries.
A utilities company, a carmaker, or any other industry that consumes capital would probably have to borrow heavily to fund the revenue-generating capital.
What we tried to emphasise was that EV is not as helpful when comparing companies that are at roughly the same stage in their growth cycle; a high-growth company is less likely to carry the debt levels of one in maturity.
How Is Enterprise Value Different From Market Cap?
For businesses with either material cash reserves or debt, enterprise value is a more thorough calculation that provides clearer insight than market cap into the real value of the business.
Market Cap vs. Enterprise Value
| Entity | Market Cap | (+) Debt | (-) Cash | =EV |
| Company A | $50B | $2B | $0 | $52B |
| Company B | $50B | $0 | $2B | $48B |
For companies with either big cash balances or a significant amount of debt, enterprise value is not only more comprehensive, but also gives us a clearer idea than market cap does of a company’s true valuation.
Enterprise Value Explained with Examples: Nike vs. Home Depot
Enterprise value (EV) is a measure of a company’s total value, and it is often used as a more comprehensive alternative to determine market capitalisation by including a firm’s debt and cash position in the valuation.
Look at these examples, where we illustrate how EV can vary based on a company’s financial composition.
Nike
- Nike’s enterprise value is not much different from its market cap, since the amount of cash and debt balance each other.
- By July 2020, Nike had $9.66 billion in outstanding debt and $8.79 billion in cash equivalents. This brings us to a debt balance of $870 million.
- With a market cap of $153.54 billion, NKE’s enterprise value is approximately $154.41 billion, which is also less than 1% above its market cap and shows that when debt and cash are very close in size, they will tend to narrow the gap between EV and market cap.
Home Depot
- The difference between the market cap and enterprise value for Home Depot is largely higher because of a greater amount of net debt.
- Home Depot had $31.48 billion in debt and only $2.13 billion in cash as of March 2020, for a net debt position of $29.35 billion.
- At that point in time, its market cap was $195.35 billion, and the enterprise value would have been $224.70 billion — roughly 15% higher than the market cap.
What we offered were examples of how debt can really boost enterprise value well above market capitalisation.
How Can You Use Enterprise Value as an Acquirer?
If you are considering buying a public company, enterprise value provides information about the debt and short-term assets linked to that business and how they might affect your offer.
Suppose you are considering acquiring two public companies which you find equally attractive.
Company ‘A’ has a market cap of $400m, while company ‘B’s market cap is $460m. Therefore, you would expect to pay $60m more for Co B. Right? However, as you walk through the enterprise value equation, you realise that although neither company carries any debt, company A has $20 million in cash reserves, and company B has $80 million.
Their enterprise values are therefore the same. You might still be able to rationalise bidding $60 million more for company ‘B’, though, given the balance sheet as a counterweight to the higher price.
The Right Way to Leverage Enterprise Value in Evaluating Acquisition Plans
That is something you would find interesting to explore for sure.
If you are fielding multiple acquisition offers, and if those offers are in the form of stock, as opposed to cash payments, then, in fact, what matters is comparing the value of the bids with your own enterprise value for each potential buyer.
So if the potential acquiring company has a heavy debt load and little cash on its balance sheet, that would drive up the enterprise value. Second, some industries have a higher propensity than others to be capital-intensive and, accordingly, they are subject to companies in those industries which are highly leveraged.
It is also worth noting that, unless the acquired company is left as a separate legal entity, it will not share liability for debt.
Only enter the deal if you are confident that the debt can be serviced. Ensure you have run through a scenario analysis with your financial and legal advisors before cutting a deal.
Why is Enterprise Value Important for Your Business?
Understanding EV can be helpful for a number of reasons, from evaluating potential acquisitions to determining the merits of stock-based offers.
EV is also an important component of numerous valuation multiples. For example, the EV/EBITDA ratio, which divides enterprise value by earnings before interest, taxes, depreciation and amortisation, is often used to compare similar companies.
EV is also central to many additional valuation measures.
Common Mistakes When Calculating Enterprise Value
Enterprise value (EV) is seemingly simple to calculate, but even pros in the field can make mistakes.
Often, it would be a slight misunderstanding or miscalculation which could result in significantly misrepresenting the real value of a company, and thus lead to a bad investment decision, or paying too much during an acquisition.
In the section below, we briefly offer some of the more typical mistakes many people commit:
Ignoring Off-Balance Sheet Debt
Some companies hold debt that does not show up directly on the balance sheet, like lease obligations, pension liabilities or contingent liabilities. Failure to factor the hidden debts in such a scenario can cause a company to appear less leveraged than it is and understate enterprise value, thereby deceiving potential acquirers.
Miscounting Cash Reserves
The treatment of cash and cash equivalents may be deducted when determining EV, but analysts tend to forget about restricted cash or the money being held in subsidiaries.
Treating all cash as available inflates the amount of the cash deduction, and in turn understates the actual cost to acquire the business. Proper accounting means a lot when speaking of cash, especially given the EV calculations.
Misinterpreting Market Capitalisation
Many believe market cap, alone, is indicative of a company’s value -this neglects debt and cash. It can be skewed if stock price changes are misread, or if the count is not properly multiplied by outstanding shares.
For example, a stock with a price trading downward but large numbers of shares may have the same market cap as a more expensive stock, even though the EVs requisite to drive that market cap are very different.
Overlooking Short-Term and Long-Term Liabilities
Analysts, however, frequently leave out certain short-term liabilities from such calculations — like accounts payable or near-future interest payments. Ignoring these liabilities may result in an understatement of enterprise value, unrealistic acquisition bids and inefficient investment comparisons.
Failing to Adjust for Industry-Specific Factors
Companies in capital-intensive industries or sectors experiencing high growth may possess financial structures that are different from the average. It could be misleading to ignore attributes such as capex, leverage or cyclical cash flow in the EV calculation.
Adjustments are proper so that the valuation mirrors actual acquisition expense and business risk.
Understanding Enterprise Value for Acquirers
If you are an acquirer, you can use a business intelligence system to evaluate enterprise value by integrating financial information, such as debt, cash and market capitalisation. It allows you to have a real-time, clean view of companies’ total valuation, so you do not take a larger risk with your acquisition decisions.
Advanced Analytics with TigernixBI
TigernixBI is a robust Business Intelligence System built with Analytics that allows you to use sophisticated analytics to model corporate value under a range of scenarios, including debt load or cash reserve, and see the likely impact on share price or market trends. This feature lets buyers model out various deal structures and see how changes impact the overall valuation of the company.
Reports And Insights For Operation and Development Opinions You Can Trust
TigernixBI delivers partial findings of targets to the acquiring companies with versatile dashboards and exhaustive reports. It also highlights EV drivers, compares more and better opportunities and allows informed decisions, all with a view to making the acquisitions that best fit in line with financial strategy and delivering optimal business value.
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FAQ about Enterprise Value
Why do Businesses Deduct Cash from Enterprise Value?
Businesses deduct cash from enterprise value as it is often used as a measure that captures the expected cost to purchase a business, and since the cash a business holds in its treasury would, from the perspective of the new owner, be liquidated or spent on other purposes, it serves to reduce the overall cost.
What is Considered a Good Enterprise Value?
A good enterprise value is a ratio under 10, as it is known to be attractive, but investors should note that ‘healthy’ levels of EV / EBITDA will differ greatly between sectors and market conditions. It takes into consideration a company’s debt and cash on hand so that investors can see what a company is really worth and how efficiently it is operating.
Can Enterprise Value be Less than Equity Value?
Yes, enterprise value can be less than equity value. This happens for companies with net negative debt, or for certain other companies, such as those with a cash balance in excess of the total debt position.
Is a 30% EBITDA Margin Good?
A 30% EBITDA margin implies that a company earns 30 cents in profit for every dollar of revenue it collects. A good EBITDA margin is a sign of low operating expenses and high earnings potential.
Why do Businesses Use Enterprise Value?
Businesses use enterprise value to measure the cost of acquiring a company, especially if they have different capital structures. The EV adjusts for more than just outstanding by factoring in debt and subtracting cash from the cost, making it possible to calculate what a company is worth.
