Enterprise value (EV) represents the total value of a company. While market capitalization is the total value of a company’s equity share, enterprise value is the total value of the whole company because it factors in the company’s debt and cash holdings.
In other words, Enterprise Value (EV) measures the value of the assets that produce the company’s product or service; both the equity capital (market capitalization) and debt capital. Because it measures the productive assets it is a valuable measurement for key ratios such as Return on Enterprise Value (ROEV).
Calculating Enterprise Value
Enterprise Value (EV) = Market Capitalization + Total Debt – Cash
The idea of calculating EVis to know what it would cost to purchase the entire company or business. In order to calculate the total value of a business a buyer would add equity (market capitalization) and debt, and subtract cash. Debt increases the cost of acquiring the company, so it is added. Cash would be an asset that could offset debt or be absorbed by the acquirer, to it is subtracted from the equation.
Why is this Company Valuation Method Important?
Enterprise value (EV) is a measure of the economic value of a company. Because allowances for liabilities and cash are made; EV is a capital structure neutral metric. This makes it extremely useful in analyzing and comparing companies with different capital structures.
Market Capitalization and Enterprise Value
Example of Difference
Companies with identical market capitalizations can have radically different enterprise values. Company A may have considerable debt and little cash, while Company B might have little debt and considerable cash.
_________Market Cap. + Debt – Cash = EV
Company A: 5 billion + 5 billion - 1 billion = 9 billion EV
Company B: 5 billion + 0 billion - 2 billion = 3 billion EV
Both companies have a 5 billion dollar market capitalization but Company A has an EV of 9 billion and Company B an EV of 3 billion. When comparing company A to company B, company A is riskier than company B because it has a high amount of debt. Also, company A would have to provide a much higher return in dollars to compensate for its high value and greater risk.
Enterprise value (EV) is my favorite company valuation method. I constantly use it to compare investment opportunities. When you buy a stock you are buying a percentage share of the whole company. EV is the current market price if you were purchasing the entire company. Why would you value a company differently just because you are buying only a percentage?
Analysts use metrics such as revenues, EBITDA, and net cash flow in relation to EV for the purpose of comparing company valuations. The key is to remember enterprise value is the total value of the whole company and extremely useful in analyzing and comparing companies with different capital structures.
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