Enterprise Value, also sometimes referred to as EV, is a measure of a company’s total value, and is often used as an alternative to market capitalization. EV represents the theoretical price of a business if it were to be purchased. Because EV accounts for a company’s debt and cash assets, it is considered to be a more comprehensive valuation method versus other valuation methods, including market capitalization (which looks at a company’s outstanding shares).
EV can be thought of as the theoretical takeover price if a company were to be bought. It differs from simple market capitalization model mainly because the value of a company's debt would need to be paid off by the buyer, thus, Enterprise Value provides a more realistic takeover amount because it includes net debt in its valuation model.
Calculating Enterprise Value
Enterprise value is calculated as market capitalization plus debt, minus total cash and cash equivalents. Check out the formula below:
Enterprise Value = Market value of common stock + Market value of preferred equity + Market value of debt + Minority interest – Cash and investments
In some cases, analysts may adjust the debt portion of the equation to include preferred stock, and the cash portion of the formula may also be adjusted to include other cash equivalents, such as accounts receivable and liquid inventory.
Breaking Down the EV Formula
Market Capitalization – Describes the current market value of the common shares of a company (calculated as the current share price multiplied by the number of equity shares outstanding).
Debt – Includes bonds and bank loans, and must be included in the enterprise value calculation since any outstanding debt will become the responsibility of the purchaser when the company is sold.
Related: How to Sell a Business With Debt
Preferred Shares – These shares represent a claim on the business and in some cases may be factored into the EV calculation.
Minority Interest – A non-current liability that represents a subsidiary corporation’s stock, owned by minority shareholders.
Cash and Cash Equivalents – This includes cash on hand, cash in a bank or financial institution, and highly liquid short-term investments that can be quickly and easily converted to cash. As described above, in some cases, accounts receivable and liquid inventory may also be included. Cash and cash equivalents reduce the acquisition price, and therefore must be factored into the EV formula.
Video: Tim Bennett explains simply yet professionally what is Enterprise Value, and how to calculate it.
Related: Enterprise Value defined by Investopedia
Why is EV Important?
Because it's fundamental by design.
Enterprise value is a fundamental economic measure that reflects the total market value of a business and is used regularly in business valuation, portfolio analysis, accounting, financial modeling, and risk analysis.
Market capitalization and price-earnings ratios are other valuation methods commonly used to value companies, however, in most cases, EV is a more accurate representation of actual value. EV considers a multitude of financial factors outside of the business’s outstanding equity. Any acquiring company would assume responsibility for both the debts and cash of the company being purchased, and these factors have a major impact on the company’s value.
Additionally, investors sometimes use EV to compare returns between similar companies on a risk-adjusted basis. It is important to keep in mind that it is often difficult for an outside investor to accurately asses EV since many investors don’t have access to the current market value of the company’s debt.
How Is EV Used in the Sale of a Small or Medium Sized Business?
Owners of medium and small businesses who intend to sell their business under the stock method should take time to understand the Enterprise Value concept. Under the stock method of acquisition, the cash and debt on a company’s books will remain with the buyer.
Related:
- Alternative Methods for Valuing a Business
- Business Valuation Models and Formulas (with videos and examples)
- Business Valuation Guide (by DCF-method)
Understanding the value of your business at an operational level will help you negotiate a sale. In the event you’re not planning to sell your business anytime soon, understanding the value of your business within the context of its capital structure will help you grow your business in the coming years.
This article was originally featured on ExitPromise.com
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