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Understand and Calculate Enterprise Value

June 29, 2022
8
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EV is a more comprehensive valuation because it includes a company’s debt and cash, is useful in comparing companies with different mixes of debt and equity capital.

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How much would it cost to buy an entire company, not just a piece of it? The enterprise value of the company answers that question.

Some think the value of a company is its market cap, or market capitalization. But market cap only takes into account the company’s shares, which are little pieces of ownership traded on a stock exchange. Market cap is the total value of the equity, another term for ownership. Enterprise value includes that and more.

What is enterprise value?

Enterprise value (EV) is the total cost of owning a company’s equity as well as its debt and its cash. It reflects what investors think the entire business is worth, not just what the stock is worth. Enterprise value is perceived as the theoretical takeover price of a company, and it is used frequently as the basis for merger and acquisition negotiations.

Enterprise value vs. market cap: What’s the difference?

Market cap represents only the equity value of a company—the value to shareholders, who have a claim to the company's earnings.

Enterprise value includes the value of all claims to the company’s earnings or cash, such as claims by holders of company bonds, bank lenders, and preferred stockholders.

Market cap is a simple calculation of two factors: the total number of shares outstanding, times the current stock price. So if the hypothetical company ABC Inc. has 1 billion shares outstanding and the stock price is $40, the market cap is:

                        1,000,000,000 x $40 = $40 billion

What’s the formula for enterprise value?

Calculating enterprise value is more complicated, and it has more moving parts. The main difference is that EV accounts for a company’s debt and cash, which are listed on its balance sheet.

The basic enterprise value formula looks like this:

                       Market cap + debt - cash = EV

Let’s say ABC has a $40 billion market cap, $10 billion in debt, and $1 billion in cash or cash equivalents such as U.S. Treasury bills. The enterprise value of ABC would be:

                        $40 billion + $10 billion - $1 billion = $49 billion

Market cap and enterprise value both differ from a company’s book value, which is an accounting value from the company’s balance sheet—its total assets minus total liabilities. For instance, ABC might have $30 billion in assets and $20 billion in liabilities. The book value calculation would be:

                    $30 billion - $20 billion = $10 billion, or $10 a share

Market cap is usually larger than book value because investors are willing to pay a premium for a company’s future earnings.

What makes up enterprise value?

Depending on the type of company, its capital structure (the mix of debt and equity), and whether it has subsidiaries, enterprise value consists of some or all of the following components: 

  • Equity value (or market cap). This is the starting point for calculating a company’s enterprise value. Shares outstanding are on a fully diluted basis, meaning this includes any shares that would be created from the exercise of stock options, warrants, or conversion of debt, as well as restricted shares held by company executives and insiders.
  • Total debt. If a company has issued bonds or taken out loans, these are a continuing obligation if the company were to be acquired, so they are added to enterprise value. Short-term debt, due for repayment in less than a year, is included with long-term debt for the total. Capital leases for equipment typically are treated as debt. Capital intensive industries such as airlines and shipping companies, for example, often lease planes and ships instead of buying them.
  • Preferred stock. Some companies issue preferred shares, which in some ways resemble common shares but are treated like debt because the company has specific dividend and repayment obligations. Preferred stock is added to enterprise value as debt.
  • Minority (non-controlling) interest. A company with a subsidiary that is majority-owned but not 100% owned must account for the other shareholders who hold a minority interest in the subsidiary. For example, if ABC Inc. owns 80% of a subsidiary, XYZ Corp., and includes all of XYZ’s sales and earnings in its consolidated income statement, it values the 20% held by outside shareholders and adds it to enterprise value.
  • Cash and cash equivalents. Some companies, such as Apple and Microsoft, accumulate large amounts of cash from their operations, and park it in very liquid short-term instruments such as U.S. Treasury bills, bank certificates of deposit and money-market funds. Unlike the other components, cash is subtracted from enterprise value because if the company were to be acquired, the buyer takes possession of the cash. In effect, the acquirer can use the cash to partly reimburse itself for the takeover cost.

Why enterprise value is used

Enterprise value’s main use is for mergers and acquisitions, and for financial ratios to evaluate a company’s profitability.

A prospective acquirer uses EV as the basis for determining the price it might pay for the company, while the company uses it to seek the price it would like to receive. It’s a starting point for the two sides to haggle toward a final price.

Key valuation ratios

Enterprise value ratios are used by so-called value investors, who look for high earnings or cash flows relative to stock price to identify companies they see as undervalued. They focus on cash flow rather than earnings (net income) because this sets aside costs that are influenced by a company’s capital structure, or its mix of debt and equity.

Various ratios are created with enterprise value, such as EV divided by pretax earnings, or by some measure of cash flow. Ratio analysis is done to compare a company against similar companies, and to assess whether the company may be undervalued or overvalued in the stock market relative to its profitability.

Financial ratios can be expressed as multiples or percentages of EV. For example, if ABC Inc. has an EV of $49 billion and cash flow of $4.9 billion in its latest year, its EV/cash flow multiple is:

                          $49 billion/$4.9 billion = 10

Flip the equation, to cash flow over EV, and the percentage, called a yield, is:

                        $4.9 billion/$49 billion = 0.10 or 10%

A company with a lower EV multiple, or conversely a higher EV yield, is considered a better value for acquirers as well as investors.

Four key EV ratios that focus on cash flow include:

  1. EV/EBITDA. Enterprise value divided by earnings before interest, taxes, depreciation and amortization, or EBITDA. The latter strips out any expenses—cash or non-cash—not directly related to the company’s operations. This is an alternative to the commonly used price-to-earnings (P/E) ratio, or P/E multiple. This ratio can be more useful than the P/E ratio in valuing companies that have large debt burdens. 
  2. EV/EBIT. A variation of the above, EBIT includes interest and taxes but removes depreciation and amortization from the calculation. Some investors and analysts use EBIT because interest and taxes are cash expenses to the company, unlike depreciation and amortization, which are bookkeeping entries.
  3. EV/CFO. Cash flow from operations is also sometimes used rather than earnings (net income) because it excludes depreciation and amortization. Like EBITDA, cash flow from operations will often be positive even when net income is negative. Free cash flow, a more conservative variation, accounts for capital expenses—the amount a company must spend to update or replace assets.
  4. EV/SALES. A variation of the simple price-to-sales ratio, which calculates a company’s market cap divided by its annual sales or revenue.

Limitations of enterprise value calculations

Companies vary in their mix of equity and debt capital, as well as the amount of cash they accumulate, so enterprise-value comparisons need to take these differences into account. A company with a large amount of debt and less cash will have an EV higher than its market cap. The opposite is true for a cash-rich, low-debt company: it will have EV lower than its market cap. This can make enterprise comparisons between various companies less meaningful.

The bottom line

Enterprise value is a more comprehensive valuation of a company than market cap because it includes a company’s debt and cash. EV is useful in comparing companies with different mixes of debt and equity capital. Financial ratios using EV help investors determine if a company may be undervalued relative to its cash generation, or overvalued. Merger and acquisition negotiations include analysis of EV ratios to arrive at an acceptable takeover price for a company.

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