Enterprise Value (EV) represents the total value of a company. Market capitalization valuation is the total value of a company’s equity shares, while Enterprise Value (EV) is the total value of the whole company because it factors in the company’s liabilities and cash. In other words, EV measures the value of the productive assets that produce its’ product or service; both equity capital (market capitalization) and debt capital.
Calculating Enterprise Value
Enterprise Value (EV) = Market Capitalization + Total Debt – Cash
The concept of Enterprise Value (EV) is to calculate what it would cost to purchase an entire business. In order to calculate the total value of a business an acquirer (buyer) would add equity (market capitalization) and debt, and subtract cash. Debt increases the cost of acquiring the company, so it is added (a penalty). Cash would be an asset that could offset debt or be absorbed by the acquirer, so it is subtracted from the equation (a reward).
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 EV 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 (EV). 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 Enterprise Value of 9 billion and company B an EV of 3 billion. When comparing company A to company B, company A is riskier that 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’ higher value.
What is the best measure of return to compare to Enterprise Value? In my next posts we will look at “What is Net Cash Flow?” , and “The Best Stock Valuation Calculation to Value Company Shares”.
| AAAMP Blog by Ken Faulkenberry | |
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Ken Faulkenberry earned an MBA from the University of Southern California (USC) Marshall School of Business with an emphasis in investments. Ken has 25 years of investment experience and is dedicated to helping people with self-directed investment management through the Arbor Investment Planner. His asset allocation strategies have an outstanding performance record. |
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