What is Enterprise Value?
Enterprise Value (EV) is simply the total price that you need to pay to acquire 100% of any company. EV is also known as the Total Enterprise Value (EV) or Firm Value (FV).
How is Enterprise Value calculated?
EV is simply the summation of market value of common stock, preferred equity and debt, minority interest, minus total cash and cash equivalents. The formula is:
Enterprise Value= Market Value of Common Stock + Market Value of Preferred Equity + Market Value of Debt + Minority Interest – Total Cash and Cash Equivalents.
Market Value of Common Stock = Market value of equity shares.
Market Value of Debt = Bank loans, bonds, etc. which are to be dealt by the acquirer.
Minority Interest= It is defined as the portion of subsidiaries held by the minority shareholders.
Cash and Cash Equivalents= Highly liquid investments, cash in hand and cash in bank.
Since the purchaser of the company is liable to pay for debts of the company, therefore debt is added which increases the purchasing cost of the company. On the other hand, cash and cash equivalence is an asset which would be received by the acquirer. Therefore, it is subtracted from the Enterprise Value.
Understanding EV through an example:
Consider two companies A&B with the same equity capitalisation. While company A has debt on its balance sheet, company B is debt-free. Even when both the companies operate on zero cash, the EV of company A would be higher.
The following table summarises the results:
The above table signifies that the debt component significantly impacts the Enterprise Value. In the above table, even though both the companies have the same market capitalization, the company with a debt of 30 crores in its books is more expensive than the company with zero debt. In other words, debt increases the purchasing cost of the company thereby making it more expensive.
Any acquisition of assets through cash or issue of shares increases the enterprise value of the company. A reduction in capital intensity, for instance, a reduction in working capital decreases the enterprise value. Also, enterprise value of the company may be negative if the company holds too much of cash and cash equivalents. Holding too much of cash signifies that the company is slacking in terms of investing in profitable assets which would have otherwise increased its profitability.
Importance of Enterprise Value.
In today’s competitive world, managers need to be ensured about the worth of the company they plan to acquire. In that scenario, EV presents the theoretical acquisition price of the company. It provides an accurate value of the firm. Thus, EV is of extreme importance in times of mergers and acquisitions.
Since the EV includes the debt component, therefore it is handy when we are required to compare the capital structures of different companies. Comparison of capital structures is another crucial factor in the acquisition transactions.
The EV is often used in multiples such as EV/EBITDA, EV/FCF or EV/Sales since for the stock market investors. It allows comparison of returns by providing better information. It is also a better measure than the Price/Earnings Ratio since the latter does not take into account the cash and debt component. The multiples are described below:
EV/EBITDA: The ratio of EV/EBITDA gives us a picture of what we need to pay to acquire the company as a proportion to the earnings of the company from its core operations.
The thumb rule is that lower the EV/EBITDA ratio, better it is since a lower ratio would mean higher earnings and therefore higher possibility of returns.
EV/FCF: Enterprise Value to Free cash flow is the total valuation of the company relative to its ability to generate cash flows. Lower the ratio, the faster would be the ability of the company to generate cash flows which can be reinvested into the business.
EV/Sales: It is a relevant ratio since it accounts for debt component that needs to be paid back. Lower the ratio, more attractive and undervalued the company is.
How is Enterprise Value different from Net Worth?
Net worth or Equity Value is the value that remains with the shareholders after paying off all debts. On the other hand, Enterprise Value is the cost of buying the right to the whole of an enterprise’s core cash flow. It is thus the total cost of purchasing the company.
Let us understand the difference through the following example:
Suppose you decide to buy a car at Rs 10,00,000. You pay Rs 4,00,000 as down payment while you borrow the rest Rs 6,00,000 from a lender. In this scenario, the down payment of Rs 4,00,000 is your equity value while the entire value of your car, i.e., Rs 10,00,000 is your Enterprise Value.
Even though EV is an advantageous method of valuing companies, it is not free from limitations as described below:
Let’s suppose the company has invested too much in unprofitable businesses. This would mean excessive debt in the books of the company. Even though the unprofitable ventures would not be contributing to the company, they will end up overvaluing the company. Thus, EV will give a false idea to the potential acquirers about the competitiveness of the company. So significant evaluation of the fundamentals is required before going for an acquisition.
While comparing one company to other, we can use EV multiple only when both the companies operate in the same industry because the capital structure and requirement tends to be different for different industries.