What is the enterprise value (EV)?
Enterprise value (EV) is the total value of a company. It includes the market capitalization of a company and all liquidassets in the balance sheet, as well as current and non-current liabilities. Enterprise value is often used as an alternative to the market capitalization of equity. It is often part of the discussion on mergers and acquisitions to determine the value of the companies concerned.
Enterprise value is a calculation that theoretically represents the total cost of a company if it were to be taken over by a single company. For a listedcompany, this would mean that all shares would be bought out and the company would go private. EV provides a more accurate estimate of the takeover cost than market capitalization because it takes into account a number of other important factors such as preferred stock, debt (including bank loans and corporate bonds), and excess cash. Enterprise value is essentially a modification of market capitalization as it includes debt and cash to determine the value of the company.
The formula for calculating the enterprise value
To calculate the market capitalization, the number of shares in circulation is multiplied by the current share price. In most cases, the value is already stated in the company’s reporting. All debts in the company’s balance sheet are then added together (current and non-current debts). The values of market capitalization and total debt are added together and then all cash and cash equivalents are deducted.
EV = market capitalization + total debt – cash and cash equivalents
In other words, the EV is the amount it would cost you to buy every single common share and preferred share of a company, as well as the outstanding debt. You would deduct the cash on hand because once you have fully acquired the company, the cash is yours.
The components of enterprise value
Market capitalization
Market capitalization is the number of ordinary shares multiplied by the current price per share. For example, if a company has 1 million shares in circulation and the current share price is CHF 20 per share, the company’s market capitalization is CHF 20 million.
Indebtedness
It is not only the value of ordinary shares that reflects the value of a company. Suppose a company is in debt because it has invested in better machinery and infrastructure. This is also assumed when you buy the company. Once you have acquired a company, you have also taken on its debt.
Cash (and cash equivalents)
When you buy a company, you own all the cash in the bank. They serve to reduce your acquisition price. For this reason, you should deduct them from the other components when calculating the value of the company.
Preference shares
Although they are technically equity, preference shares can function as either equity or debt, depending on the nature of the individual issue. A preferred share that must be redeemed at a certain price at a certain time is debt in all respects. In other cases, preference shareholders may have the right to a fixed dividend and also share in the profits. Preference shares that can be converted into ordinary shares are referred to as “convertible preference shares”. Nevertheless, the preference shares represent a claim on the company that must be taken into account in the enterprise value.
The use of enterprise value (EV)
The enterprise value can be used to determine the value of an investment in a company compared to its competitors.
Some investors, particularly those who follow a value investing philosophy, look for companies that generate a high cash flow in relation to their enterprise value. Companies that fall into this category are more likely to require little additional reinvestment.
However, using enterprise value as the sole method for valuing a company also has disadvantages. A high level of debt, for example, can make a company appear less valuable, even if the debt is used appropriately.
Companies that need a lot of equipment are often highly indebted, but so are their competitors. For this reason, it is best to use enterprise value to compare companies in the same industry, as their assets should be used in a similar way.
EV as a valuation multiplier
Enterprise value (EV) is often used in the formula for calculating financial ratios. The financial ratios are used to measure the performance of the company. In most cases, the profit, or part of the profit, is set in relation to the enterprise value. The measure of profit can vary, e.g. earnings before interest, taxes, depreciation and amortization (EBITDA).
EV/EBITDA
The EV/EBITDA ratio is used to compare the value of a company, including debt, with the company’s cash earnings less non-cash expenses. It is ideal for analysts and investors who want to compare companies within the same industry.
Advantages:
- The ratio can be more useful than the price/earnings ratio (P/E ratio) when comparing companies with different levels of debt.
- The ratio is also advantageous for the valuation of capital-intensive companies with high depreciation and amortization, as these are not taken into account in the ratio.
- EBITDA is usually positive, even if earnings per share (EPS) are not.
Disadvantages:
- As working capital grows, EBITDA will overstate operating cash flow (OCF). In addition, this key figure does not take into account how different revenue recognition strategies can affect a company’s OCF.
- As the company’s free cash flow captures the number of capital expenditures (CapEx), it is more closely linked to valuation theory than EBITDA. EBITDA is generally an appropriate measure when capital expenditure is equal to depreciation and amortization expense.
EV/sales
An equally frequently used multiplier is EV/sales. EV/sales is considered a more accurate indicator than the price/sales ratio as it takes into account the value and amount of debt that a company will have to repay at some point. A low EV/sales ratio indicates an undervalued company. The EV/sales ratio becomes negative when a company’s cash exceeds its market capitalization and debt value.
Price/earnings ratio (P/E) vs. EV
The price/earnings ratio (P/E ratio) is the ratio of the current share price to earnings per share (EPS). The P/E ratio is also known as the price multiplier or earnings multiplier. Unlike the EV, the P/E ratio does not take into account the amount of debt a company has on its balance sheet. In general, it is worth calculating both ratios.