Market capitalization (the share price of the company’s stock multiplied by the number of shares) is just one way to estimate the value of a company. Sophisticated investors rely much more on enterprise value, which includes market capitalization along with cash on hand minus short-term and long-term debts.
Gaurav Sharma, Founder of BankersByDay, explains that enterprise value is an approximation used to quickly compare companies, making it easier to see how one is performing within the industry.
To help entrepreneurs and business owners understand how investors use enterprise value to estimate a company’s worth, we’ve outlined how to calculate enterprise value, when to use it, and how to use it in combination with other financial formulas.
The purpose of enterprise value
Unlike market capitalization, enterprise value takes into account a company’s debt and cash reserves, which are two key measures important to determining a company’s takeover price.
Mat Hultquist, CPA and president of The Hultquist Firm, says enterprise value is the cost of buying a company outright, plus the entire debt and minus the cash on the company’s books. Sharma adds that enterprise value “increases the price that you will have to pay by adding debt, and then reduces it to the extent of liquid cash available.”
Experienced investors realize the enterprise value of one company won’t tell them much by itself. The big picture requires comparing the enterprise value of the company being considered for takeover against the enterprise value of each competitor.
Elements of enterprise value
The enterprise value formula is a simple calculation, but you have to understand its components to get the most out of it.
Market Capitalization = Price per share x Total number of outstanding shares
For example, a company with 20 million outstanding shares selling for $30 per share has a market capitalization of $600 million. Market capitalization is an important component when calculating enterprise value.
Joel Salomon, CFA, FSA, and chief prosperity officer of SaLaurMor, explains that because the current share price is determined by the public market, market capitalization is important when comparing the company to its competitors.
However, experienced investors never rely solely on market capitalization when determining how big a stake to buy in a company. The enterprise value calculation is the cornerstone of their analysis, not least because share prices can go up and down for reasons unrelated to more important metrics.
Total debt is the next factor in the equation. This includes the company’s short-term and long-term debt. To determine this number, add the company’s short- and long-term debt together.
Total Debt = Short-term debt + Long-term debt
Cash on hand
The final factor in determining enterprise value is cash on hand. This is money in bank accounts, literal cash in the registers at company stores, and cash equivalents (often called liquid assets) such as mutual funds, bonds, and money market funds that can be easily and quickly converted to cash. This calculation might even include expected payments for goods or services already sold:
Cash on hand = Cash + Cash equivalents
Enterprise value formula
With the above numbers in hand, you can now calculate and compare the enterprise value of competing companies. Enterprise value basically nets out that cash and debt component, and boils down to what you’re paying for the underlying business, excluding the cash and the debt.
The enterprise value formula is
Enterprise Value = Market capitalization + Total debt – Cash and cash equivalents
To see this play out, let’s first calculate the enterprise value of one company and then compare it to competitors. For the sake of simplicity, we’ll use much smaller numbers than you would typically see in the marketplace.
Price of share: $6
Total outstanding shares: 1,000
Short-term debt: $4,000
Long-term debt: $5,000
Cash and cash equivalents: $8,000
1. First, determine the market capitalization, which is the price of one share ($6) multiplied by the total outstanding shares (1,000), which equals $6,000.
2. Net debt is the short- and long-term debt added together ($4,000 + $5,000), which equals $9,000.
3. Add the market capitalization to the net debt, which equals $15,000.
4. Subtract the cash and cash equivalents ($8,000) to arrive at $7,000, the enterprise value.
($6 x 1,000) + ($4,000 + $5,000) – $8,000 = $7,000
Is that number high or low? Good or bad? The only way to determine that is to know the enterprise value of other companies in the same industry. That’s why it’s valuable to look into other companies’ numbers.
Let’s consider Companies B and C, and see how they all compare.
To cut down on calculations, we predetermined the market capitalization and net debt for the following companies:
Market capitalization: $3,000
Net debt: $10,000
Cash and cash equivalents: $6,000
Enterprise value: $7,000
Market capitalization: $6,000
Net debt: $15,000
Cash and cash equivalents: $5,000
Enterprise value: $16,000
At first glance, Company A and B appear to be of equal value because they have the same enterprise value of $7,000. Yet Hultquist warns, if you only look at their total enterprise values, you’ll miss the bigger picture.
When you take a deeper look at the factors that make up enterprise value, you’ll see that Company B has a greater debt load and less cash and cash equivalents than Company A. “If a company is using a lot of debt and not much equity, it could mean they’re not that profitable, or it could mean they’re growing,” Hultquist says.
Because there are many explanations for a company’s debt load or lack of equity, it’s important to look at each individual factor before drawing conclusions.
Now, let’s compare Company C. Its enterprise value of $16,000 is more than the combined enterprise value of the other two companies. But again, look at the other driving components. Company C has very high debt and very low cash and cash equivalents. A high debt load could be a “drag on the company,” which might mean it’s a somewhat risky investment.
Digging into these factors gradually reveals the true story of the company. Successful investors determine company worth based on the financial elements that are most pertinent to them and their investment strategies.
Comparables analysis: Enterprise value ratios
Once you determine the enterprise value (EV) of a company, you can delve deeper with a “comparables analysis.” Investors run a comparables analysis to examine ratios, such as EV/sales and EV/EBITDA, that allow them to compare companies in the same industry and growth stage. These ratios are then used to make a relative comparison.
The EV/sales ratio compares the company’s enterprise value to annual sales, or revenue. This calculation (enterprise value divided by sales) is all the rage in today’s bubble market. Many new businesses currently on the market generate little revenue and spend more money than they make.
EV/EBITDA is the other commonly used ratio. It divides enterprise value by EBITDA (earnings before interest, taxes, depreciation, and amortization). Sharma says the ratio removes interest, depreciation, and amortization from the equation, which provides for better comparisons. A low ratio may mean the company is undervalued, while a high one could indicate that it’s overvalued.
Again, you won’t gain much from the ratios of a single company until you compare them with the same ratios of other companies. That deeper comparative analysis will give you a holistic view.
Understanding equity value
In addition to market capitalization and enterprise value, equity value is another term that’s often used in the financial world. Sharma says, “Equity value is the same concept as market cap. It’s just that these terms are not standardized, and there are different levels of depth you can go into when calculating them.”
Market capitalization and equity value both take into account the company’s outstanding shares, but equity value also considers mandatory and optional convertible instruments (debentures and preferred stock) and stock options, which will only be vested if they are profitable, according to Sharma.
When comparing equity value to enterprise value, equity value, like market capitalization, often helps investors make predictions about the company’s value in the future, while enterprise value conveys the company’s current worth.
Whatever calculations you use, the most important thing to remember is that you can’t determine a company’s value in a vacuum. Until you understand all the factors and formulas, you can’t begin to compare companies’ values meaningfully.