The enterprise value (EV) is a direct representative of the economic value of a company – in other words, how much money someone would have to pay in order to buy it. When you are valuing stock, it is very important to consider this number.
Indeed, the market capitalization also doubles as a company’s price tag. However, unlike the enterprise value, the market capitalization completely ignores the debt. This is a very important aspect, considering that many companies are sold because of debt – changing the number significantly. This is why the EV also includes the debt.
Understanding Enterprise Value
To get a better understanding of enterprise value, imagine that you are looking at two companies with the same market capitalization. However, one of them has a clean slate when it comes to debt while the other is drowning in it. The person that will own the latter company will have to pay a lot in interest over the years – so his profit won’t be as big compared to the one with the “clean slate.”
This is why debt is important when ascertaining the value of a company. The less debt it has, the bigger the profit will be in the long run. When you are buying the debt, you are basically buying extra expenses that may cause your new business to fail.
The Enterprise Value Formula
To calculate the EV, you need to start with the market capital of the company, to which you add the debt and subtract the investments and cash. Each of these can be found on the balance sheet. To find out your total debt, you need to add both the short term and the long-term debt.
As a result, the formula for Enterprise Value should look as follows:
Bear in mind that this is a simplified version of the equation which only looks at the current cash and the debt. A sophisticated investor with an eye for detail will also consider the minority interests, the preferred shares impact, the liquid inventory, the cash equivalents, and so on.
This would make sense, considering that the purpose of this calculation is to measure the company’s economic worth. A more cautious investor will use the following formula:
Why need Enterprise Value?
As you may have realized, this measurement has the purpose of coming up with a takeover price or business valuation. When you purchase a business, you need to know exactly how much debt you will be purchasing along with it – and how much it will cost you in the long run. This is exactly why enterprise value is a much more effective measurement compared to market capitalization.
You can go either for the short version or the long version of the equation. The longer version will give you a more detailed number; however, the shorter one will also give you a fairly good average. Chances are, the gap won’t be that big when comparing the two results.