Enterprise Value (EV) or Firm Value is an economic measure that indicates the total value of a company. It measures how much an acquirer needs to pay to buy a company. It’s one of the fundamental metrics used in business valuation and portfolio analysis.
Enterprise Value is considered to be more comprehensive and accurate than market capitalization while valuing a business. It takes into account not only the equity value of the company, but also its debt, cash and minority interest. Market capitalization, on the other hand, includes only common equity (leaving out important factors like company’s debt and its cash reserves.)
Calculating Enterprise Value of a firm
Simply put, Enterprise Value is the sum of market capitalization and net debt of a company. Mathematically,
Enterprise Value = Market Capitalization + Debt + Preferred Stock + Minority Interest + Pension Liabilities and other debt-deemed provisions – Cash and cash equivalents – “Extra Assets” – Investments
- Market Capitalization is the price of each share x number of common shares outstanding. So, if a company has 100 common shares outstanding with each share selling at $10, its market capitalization will be $1,000.
- Debt represents long-term and short-term interest-bearing liabilities at market value. Items such as trade creditors are not included. Once a business is acquired, its debts become the responsibility of the new owner (the acquirer). The acquirer will have to repay the debts using the cash generated from the business operations. Therefore, debts are added while calculating the enterprise value. Also, read Enterprise Value: Cash and Debt here
- Preferred Stocks (at market value) are essentially claims on the business that must be factored in while calculating enterprise value.
- Minority Interests, non-current liability, that represents the proportion of subsidiaries owned by the minority stakeholders. Market value of minority interest is added because it signifies a claim on the assets consolidated into the firm in question.
- Enterprise Value should also include special items such as pension liabilities, employee stock option, environmental provisions, etc. as they signify claims on company’s assets.
- Cash and cash equivalents include cash in hand, cash in the bank and short-term investments. These are highly liquid which can be easily converted into cash in a short span of time. They are subtracted in the EV calculation because they reduce the acquisition price. Also, refer my article on Enterprise Value: Cash and Debt here.
- “Extra assets” or assets that are not required to run the business must be subtracted.
- Investments in associated companies at market value are subtracted as they reflect a claim on the assets consolidated into other firms.
While I understand that it’s a long list of items that comes into play while performing the calculations, I’ll take a simple example to elucidate the concept. Suppose, a public limited company has 1 million common shares outstanding, each priced at $15. They have debt worth $1 million (including preferred stock) and cash and cash equivalent worth $500,000. The Enterprise Value or Firm Value,
EV = (15 x 1,000,000) + $1,000,000 – $500,000 = $15,500,000
Few points noteworthy
(1) EV can be negative if the company holds very high amount of cash.
(2) Increases or decreases in EV do not necessarily mean “value creation” or value destruction”.
(3) Since Enterprise Value is independent of the company’s capital structure, it’s useful while comparing companies with diverse capital structures. Price/Earnings ratio, for example, don’t take cash and debt into consideration. That’s why, P/E ratio will be negatively affected for a highly levered company.
(4) Unlike market capitalization, where both the metrics – shares outstanding and market share price – are readily available, a lot of adjustments are needed to its other components while calculating the Enterprise value.
- Vast majority of corporate debt is not publicly traded. Besides debts like bank financing and leases do not have any market price. So, debt is usually taken at face value, unless the company is highly geared (in which case, sophisticated analysis is required).
- Associates and minority interests are reflected at book values, which may be very different from their market values. They are also represented as a multiple of their earnings.
- Pension liabilities depend on various actuarial assumptions and represent an outstanding liability that may not reflect a true value. So, they are valued at face value as highlighted in notes to the latest available accounts
- Public data for components like cash, debt levels and provisions are published occasionally (often only once in a year in the annual report).
- Another challenge is with published accounts which are disclosed weeks or at times months after the fiscal year end. This means that the disclosed information is already outdated.
(5) When calculating valuation multiples like EV/EBITDA and EV/EBIT over different time frames (for example, historic multiples vs forward multiples), EV should be adjusted to reflect the weighted average invested capital of the company in each period.