What Is Enterprise Value?
Whilst many may be familiar with market capitalisation, less may be so with enterprise value, another method used to establish a company’s value. It is primarily used when talking about mergers and acquisitions, but also forms the basis of other financial metrics used to compare companies.
So, what is enterprise value? In this article, we will provide a definition of enterprise value, demonstrate how it’s calculated using the enterprise value formula and much more!
Table of Contents
What Is Enterprise Value?
Enterprise value (EV) is used in order to measure the total value of a company.
As we mentioned in the introduction, many readers may already be familiar with market capitalisation, a common method of valuing public companies. Whilst market cap measures a company’s market value by multiplying current share price by the number of shares outstanding, enterprise value takes things further.
In addition to the current market value of the company’s outstanding shares, EV incorporates debt and cash into the calculation. In doing so, it provides a more accurate picture of how much it would actually cost to acquire a company and is most frequently used for this purpose.
How to Calculate Enterprise Value
Below is the formula used to calculate enterprise value.
The calculation starts with market capitalisation which, as already noted, is calculated by multiplying current share price by the number of shares outstanding. To this figure is then added the sum of a company’s short and long-term interest bearing debt (which can be found on a company’s balance sheet). Finally, cash and cash equivalents are subtracted.
Some people may look at the enterprise value formula and read the above explanation with some confusion. Why would you add debt to a company’s value? And why subtract cash?
Remember, that the enterprise value is primarily used to establish how much it would cost to acquire a company. When purchasing a company, the buyer will also acquire its debt and its cash. This debt, then, is an additional cost which must be considered by the buyer when valuing the company. As for the cash, this, in theory, could be extracted from the company and used to offset the purchase price.
Calculating Enterprise Value Example
It is probably easiest to understand how to calculate enterprise value by looking at an example. Let’s look at Apple.
At the time of writing, Apple’s market capitalisation is $3.405 trillion which, as we saw in the previous section, will be our starting point for the enterprise value calculation. According to its most recent quarterly results, Apple had total debt of $102.593 billion and $32.695 billion cash and cash equivalents on its books.
Consequently, Apple’s enterprise value can be calculated as follows:
|
Apple Enterprise Value = $3.405 trillion + $102.593 billion - $32.695 billion
Apple Enterprise Value = $3.475 trillion |
As we can see, Apple has more debt than cash, meaning that its enterprise value is higher than its market cap. If it was the other way around, and Apple had more cash than debt, its enterprise value would be less than its market cap.
Enterprise Value vs Market Cap
When reading the financial news, you are likely to come across market capitalisation far more frequently in discussions surrounding the size of public companies.
However, when looking at things from a mergers and acquisitions perspective, enterprise value is far more useful, as the acquiring party needs to factor in debt and cash when examining a prospect.
Furthermore, enterprise value can also be helpful for investors to understand the true size and value of a company, as well as understanding how it operates. For example, you might come across a company whose market cap seems disproportionately high, but if it has minimal debt and lots of cash, the enterprise value may seem more justified.
Nevertheless, it is important to bear in mind that EV is only useful as a comparison tool when analysing companies in the same industry and at similar stages of growth. For example, companies which operate in a capital intensive industry, such as utilities, are likely to have a higher level of debt than companies operating in industries such as technology.
Metrics Which Use Enterprise Value
Besides being used to help determine the total cost of acquiring a company, enterprise value also provides the basis for several other financial ratios which can be used to compare the value of companies within the same industry.
EV/EBITDA
Enterprise value to EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortisation) is a metric which can be used to help value a company from the view of an acquirer by comparing its enterprise value to its EBITDA. It essentially shows how much an acquirer would have to pay for each $1 the company earns (before interest, tax, depreciation and amortisation) and is calculated by dividing EV by EBITDA.
EV/EBITDA is used to help ascertain whether a company is over or undervalued in comparison to its peers and, consequently, can be used to find potential takeover candidates.
EV/Revenue
EV to revenue is another valuation metric which is calculated by dividing a company’s enterprise value by its revenue. Unlike EV/EBITDA, which factors in operating costs, EV/revenue only considers the company’s total sales. Therefore, EV/revenue can be used in the same manner as EV/EBITDA but for companies which are not yet profit-making.
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FAQ
What is the difference between market cap and enterprise value?
Market capitalisation is calculated by multiplying a company’s current share price by the number of shares it has outstanding. Enterprise value uses this figure but also takes into account a company’s balance sheet by adding total debt to market capitalisation and subtracting cash and cash equivalents.
Why does debt increase enterprise value?
Enterprise value seeks to show the total cost to acquire a company. When acquiring a company, the purchaser also becomes responsible for its debt, which is why it is added to the cost of acquisition.
Why do you subtract cash from enterprise value?
When acquiring a company, the purchaser also acquires the cash on the company’s books. Consequently, this cash is deducted from the enterprise value as it can be offset against the acquisition cost.
Can enterprise value be negative?
In theory, yes. If the value of cash and cash equivalents a company has on its books is higher than the sum of its market capitalisation and total debt, then its enterprise value will be negative. However, in reality, a company’s market capitalisation is likely to reflect large amounts of cash held by a company.
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