When it comes to determining a company’s value, no single number tells the entire story. Instead, investors look at several components, such as enterprise value, to get a more holistic view of the company.
Enterprise value is a formula that factors in important financial elements of a company. Instead of focusing only on the organization’s earnings, enterprise value takes into account the organization’s debt as well.
Understanding a company’s enterprise value allows you to see where it lines up when compared to similar companies. Mat Hultquist, CPA and president of The Hultquist Firm, explains, “If you look at just one enterprise value, it may or may not mean a whole lot, but when you start comparing companies’ enterprise values within that industry, you begin to see higher and lower values.”
Components of enterprise value
Hultquist says the challenge of enterprise value is really just understanding the components that make up the formula. Those components include market capitalization, net debt, and cash and cash equivalents. When you’re wondering how to calculate enterprise value, you first need to know these variables, which are all numbers that are available to the public.
- Market capitalization is the market value of a company’s outstanding shares. You arrive at this number by multiplying the current price of one stock by the total number of shares it holds.
- Next, you need to calculate the company’s net debt by simply adding the company’s long-term and short-term debt.
- Knowing how much cash and cash equivalents the company is generating is the final factor. This refers to the company’s current liquid assets.
Calculating enterprise value
Once you have all the necessary variables mentioned above, you can determine enterprise value by adding market capitalization and net debt, and then subtracting cash and cash equivalents.
Market Capitalization = Current Stock Price x Outstanding Shares
Net Debt = Long-term Debt + Short-Term Debt
Enterprise Value = Market Capitalization + Net Debt – Cash and Cash Equivalents
To see this in action, let’s consider a company with the following numbers:
Current price of share: $5
Number of outstanding shares: 3,000
Short-term debt: $2,000
Long-term debt: $3,000
Cash and cash equivalents: $6,000
Enterprise value: $14,000
To determine market capitalization, you multiply the current price of the stock, which is $5, by the number of outstanding shares, which is 3,000, for a total of $15,000. For the net debt, add the short-term and long-term debt ($2,000 and $3,000) to get $5,000.
Now, add the market capitalization ($15,000) to the net debt ($5,000) and subtract the cash and cash equivalents ($6,000) to arrive at the enterprise value: $14,000.
That number on its own may not make much sense until you start comparing it to other companies within the same industry. This helps you gauge where the company stands.
Let’s look at another company’s numbers and see how Company A compares. To simplify things, we went ahead and calculated market capitalization and net debt.
Market capitalization: $13,000
Net debt: $1,000
Cash and cash equivalents: $5,000
Enterprise value: $9,000
In this example, Company B has a lower enterprise value than company A, but it also has much less debt. A higher enterprise value may not always mean the company is more profitable than one with a lower enterprise value.
When you understand the components that go into enterprise value, you can begin making deductions about the company’s worth. For example, Hultquist says, “Really high debt load is going to be a drag on the company,” it also means “the company with more debt is going to be riskier.”
That being said, two companies could have the same enterprise value and still have drastically different financial makeup. Let’s compare a third company:
Market capitalization: $7,000
Net debt: $6,000
Cash and cash equivalents: $4,000
Enterprise value: $9,000
Company C has the exact same enterprise value as company B, yet it has much more debt in comparison. Hultquist says you can’t take these numbers at face value, “You have to look at the details.” This is important to note because if you were to buy Company C, you’d be responsible for paying off its large debt load.
Calculating enterprise value is a great tool for helping you compare companies within the same industry, but keep in mind all the factors that go into the equation to get a better idea of different companies’ financial states.