The Enterprise Value explained.

The Enterprise Value is a metric used to determine the total value of a company if it were to be purchased entirely. It is different from market capitalisation, which considers only the common equity of all shares. The EV provides a more accurate representation of a company’s actual value in terms of its total purchase price.

The EV is independent of the capital structure and is not affected by differences in debt and equity balance. It considers all aspects of an organisation, answering the question, “If I were to buy this entire company and take it private, what would it cost me?”

When firms acquire companies, they do not simply buy all outstanding shares on the open market. If that were the case lenders may not be thrilled about this, even if equity holders are happy. Therefore, when buying an entire enterprise, all components must be considered, including debt, pension liabilities, and stock options. The market cap only looks at equity, ignoring all other components that make up the true value of a company.

Cash and cash equivalents are not included in the purchase price since they are inherited. They must be deducted from the total outlay to acquire the company.

Enterprise Value is a commonly used valuation method in mergers and acquisitions. Investment bankers and M&A firms use the EV to compare different companies when looking for opportunities for their clients.

As an entrepreneur who has bought and sold companies, I prefer using the EV metric. I think in terms of a company’s total value, even though it is not a conventional valuation method. I look at micro-cap to small-cap companies and ask myself, “What could this business be sold for privately, and is it under or overvalued compared to private markets?”

The key point is that the equity value of a company is the remaining value left for common shareholders, while the enterprise value represents all the contributors to capital.

What are Capital Contributors? Public markets are made up of eithier shareholders equity (Investors make capital contributions when a company issues equity shares based on a price and we buy them), and debt contributors (bonds, bank loans). Both provide a company the capital to operate.

What is the Enterprise Value formula?

The formula is very simple and all the information can be found publically.

+ Market Cap = Total Shares Outstanding x Current Share Price. The common shareholders are only one group of capital contributors that make up the equity value.

+ Debt = Total short and long-term debt found on the balance sheet. This makes up the second group of capital contributors. Banks and other creditors.

+ Non-Equity Claims = This is made up of all the other components such as minority interest holders (Noncontrolling interest is the portion of a subsidiary not owned by the parent company), preferred equity (This is treated like debt because they pay a fixed dividend and have a higher priority in asset and earning claims than common stock holders), and pension liabilities.

– Cash = All the cash and cash equivalents such as marketable securities, and short-term investments that the business holds. We subtract cash because an acquirer can use the cash immediately to pay off purhcase price.

How to use the EV Ratio?

The Enterprise Value is a great way to compare businesses in similar industries, with similar capital structures. The industry is important because we cannot compare a company in a sector that does not require a lot of debt to operate against one in a capital-intensive industry. One consideration of the EV is to understand how companies make use of the debt they carry. The other issue is debt is not always well-reported on the balance sheet, so really digging into liabilities is important.

In our simplified example let’s show how the enterprise value creates a different picture of two companies with the same Market Cap. If we were in the fortunate position to acquire an entire company, we would want to know which one has greater value.

Enterprise Value	Company A	Company B
Market Cap (Equity)	$5.5 billion	$5.5 billion
(+) Total Debt	–	$1.2 billion
(+) Preferred Equity	$98 million	$133 million
(+) Minority Interest	–	$5 million
(-) Cash	$1.2 billion	$75 million
Enterprise Value	$4.39 Billion	$6.76 Billion

The EV is not friendly towards the company with debt on the balance sheet. It favours the business with cash holdings as it can be deducted from the market cap. Other valuation metrics, such as the price-to-earnings ratio, usually don’t take cash and debt into account which is a considerable contribution to the value of a business.

If we were to make a purchase or bolt on an existing business and we were presented with these two opportunities Company A provides a more compelling acquisition.

So the question is how is all of this useful as an investor who is only buying a slice of shares? Investors can use the EV like the other ratios instead of the price to estimate a company’s size and worth. Instead of Price-to-Sales we can use th EV/Sales ratio. Price does not consider other areas like the debt and cash holdings. Similiar to the Price-to-Earnings we can use the EV/EBITDA ratio (which is in another blog).

Understanding what the EV is and how to work it out can create the base for other forms of valuation.

In Summary…

In M&A the EV is usually the base starting price as there is usually a premium to buy a company, especially profitable ones at the beginning of a growth cycle (welcome to the hidden cost of Goodwill).

I find the EV very useful when comparing companies in the lower market cap range and in high growth. They are less likely to have the debt as a more mature company and are often the target for M&A and investment bankers looking to take the company private again. If a smaller-cap company has very positive signs of growth and strong operating margins, there is little doubt there are eyes already on it.

Picture for example a technology company in growth mode, the market cap may show the company trading at a premium. When we use the EV, we consider the premium and then see if the company has large cash holdings and minimal debt. Taking the cash away from the market cap shines a different light on value as it may not be so expensive then. The reverse is true, picture a company that may be considered cheap, if we use the EV and see it has a huge debt on its balance sheet the total EV may be considered expensive to its peers.

Enterprise value is a useful tool for investors to determine the actual size and worth of a company. It takes into account the company’s use of debt, which can reveal potential risks and provide a more accurate valuation. EV can also help gauge a company’s profitability by considering its assets and liabilities. Despite its limitations, EV is a great way to determine a business’s worth.