Enterprise value (EV), a financial metric, is the total value of a company that includes both equity and debt holders. The company’s market capitalisation is added to its debt and less cash, and this is EV. Because it gives a business valuation metric that we can use to compare and benchmark companies of different sizes and industries, enterprise value is important for financial and strategic buyers, a multiple of EBITDA (earnings before interest, taxes, depreciation, and amortisation) is the most common method to calculate enterprise value.
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An analyst can’t conclude just by considering EV. However, if they use EV as enterprise multiples, suddenly, it appears to be very meaningful. A company with a higher EV or EBITDA is less valuable than one having an inferior enterprise multiple like EV or EBITDA. A negative EV means the company is in a strong net cash position.
Enterprise Value (EV): Overview
The most common metric we use in business valuation is enterprise value. Market capitalisation (market cap) is another commonly used metric in business valuation. The difference between enterprise value and market capitalisation can be illustrated by the simple example of the house’s value if it has a mortgage. A company’s enterprise value would be equal to the house’s value, and a company’s equity or market value would be the sum of the outstanding mortgage and its value.
Private business owners know that it is important to understand the enterprise value. However, it is just as important to know the company’s equity valuation. You can use the equity value to determine how much money you will be able to leave your company after it is sold and all debts are paid off.
The Importance of Enterprise Value
- It is the economic value of the business.
- It gives us an indication of the company’s theoretical takeover price (worth).
- Stock market investors use it to reduce risk and compare returns.
- It assists in valuing capital-intensive businesses and compares companies with different capital structures.
Also Read: Know about Balance Sheet – Definition & Examples
Enterprise Value Formula
Here’s a simple formula to calculate EV:
EV = market value of equity (market capitalisation) + the market value of debt – Cash and other equivalents
Another formula is available for EV calculation:
EV = debt’s market value + preferred share + common shares + minor interest – cash and other equivalents
It is possible to determine the value of assets held by a company. However, determining each asset’s value can be difficult and time-consuming. Instead, we could look into how the assets were bought.
This simple accounting equation can help you understand how assets are viewed. It includes the application of liabilities, funds and shareholder’s equity. These funds are used to finance assets. Value refers to the company’s current or market value, including the market values of the liabilities and equity.
Limitations in the Calculation of Enterprise Value
Be aware of some drawbacks before you use the enterprise value formula. Enterprise value also includes total debt, and you need to consider how the company used this debt. Businesses typically have a high level of debt in capital-intensive industries. This debt is used to stimulate growth (funding, investments, equipment purchases, etc.). These companies would see their enterprise value calculations biased against them, but you might miss the larger picture if you rely solely on enterprise values.
When is the Enterprise Value Formula Appropriate?
The enterprise value is the potential takeover price for a company. Because it incorporates debt into its valuation framework, enterprise value is more accurate than market capitalisation. We can use enterprise value calculation to compare businesses with different capital structures.
Enterprise value helps calculate various financial metrics and ratios, such as EV or EBITDA and EV or sales, so it’s important. Analysts often use these types of ratios to compare the financial performance of companies.
Elements of EV
We can calculate the equity value by multiplying its current stock price by the number of fully diluted shares outstanding. This includes warrants and in-the-money options. A firm must pay at most the market capitalisation value of another company if it wants to purchase it. The EV equation does not include all items, and this is because it is not a reliable indicator of a company’s true value.
Stock with Preferred Status
A type of hybrid security with both equity and debt, preferred stocks are referred to as a hybrid security. They are more similar to debt because they pay predetermined dividends and prioritise asset and earning claims over common stock. Their repayment takes place in the same manner as debt.
Total Debt
Total debt is the contribution of all creditors to the Bank. These are both interest-bearing obligations and include both long-term and short-term debt. The acquirer may use cash from the target company to pay a portion of the assumed debt. In theory, this would allow the debt amount to be modified by taking money out of it. If the debt’s market price is unclear, we can use the book value of debt in place of its market value.
Money and Its Equivalents
This is the most liquid asset in a company’s financial statements. Examples of cash equivalents include short-term investments such as commercial paper, money market funds and marketable securities.
This amount is deducted from EV because it lowers the target company’s acquisition costs. The acquirer will use the cash to pay a portion of the purchase price immediately, and the cash could be used immediately to pay dividends or buy back any outstanding debt.
Interests that are not Commanding (Minority)
Non-controlling interests are the portion of a subsidiary that the parent company doesn’t own. These financial statements are combined with the financial results of the parent company.
We include it in the enterprise value calculation because the parent company has consolidated financial reports with this minority interest. Despite not owning 100%, the parent company accounts for 100% of revenues, expenses and cash flow in its statistics. The total value of the subsidiary is included in the EV.
Also Read: Owner’s Equity: What is it and How to Calculate it?
Enterprise Value vs Market Capitalisation
- Enterprise value is primarily used in multiple analyses. However, the market is hardly used in such analyses.
- Market capitalisation valuations rely entirely on equity stock. Enterprise value valuations take into consideration cash and debt.
- A company’s enterprise value will always be higher if it has positive debt. The market cap will be higher than the enterprise value if the company has a net cash position (debt less than cash & equivalent).
- We can use the market cap to categorise companies into the brackets of small-cap or mid-cap. Enterprise value can’t serve that purpose.
It is clear from the above factors that each financial metric has different methods of determining the company’s market value. Investors use the market cap to determine the company’s size and value, and it is not based on equity value. Investors use enterprise value to measure the company’s overall market worth.
It includes the company’s equity, debt and cash & cash equivalents. Both metrics can be very useful, but investors prefer the enterprise value over the market capital. This is because it allows for a more accurate valuation of the company, and analysts can better predict its future growth.
Conclusion
A detailed analysis of the company’s fundamentals and comparison with its peers is compulsory before any investment. Enterprise value is a key component in the analysis of a company’s fundamentals and in helping to compare it with its peers. Investors can better understand whether a company is undervalued using enterprise value rather than market capitalisation.
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