Imagine that you just bought a used car for $10,000 and upon driving it for the first time, you discovered $2,000 cash in the trunk. What is the true cost of your purchase in this scenario? It will be $8,000 because the cash will offset your purchase price.  

This is the concept behind enterprise value, a common substitute to market capitalization that investors price the business at. 

Enterprise value is often considered as the purchase or “takeover” price of a business. This metric calculates the business value by including short to long-term liabilities such as debt, and any cash remaining on the balance sheet. Cash in this instance doesn’t include marketable securities, just liquid cash.

More specifically, a company’s enterprise value is calculated by the following

equation:

Enterprise Value = Market Cap + Total Debt  − Cash

To get the market capitalization of a company, take the shares outstanding and multiply the sum of shares by the current share price. Afterwards, we can find the total short-term and long-term debt on the company’s balance sheet. Finally, find the total cash on the company’s balance sheet and subtract it from the total.

It is important to note why cash is subtracted while debts are added in the equation. Cash on the company’s balance sheet, since it’s a liquid asset, can be used by the purchaser of the company to fund the acquisition, just like the car purchase example above. This is why it is subtracted because it reduces the price. Conversely, debt is added in the equation because it’s considered an expense. It must be paid off in combination with the acquisition.

Enterprise value can also sometimes get mixed up with book value, which are not the same. Enterprise value utilizes the price of the company attributed by market participants, whereas book value determines equity valuation through subtracting total liabilities from its total assets.

Why is Enterprise Value Important

Finding the enterprise value of a company works wonders in more ways than one. This is because the EV can be used in combination with many financial ratios that measure the financial stability, health, and performance of any given company. The EV is considered a more accurate measure of a company’s total equity value because it factors in debt and cash on hand.

To illustrate how enterprise value can be included in commonly used multiples, let’s take the

price-to-sales (P/S) ratio.

By definition, this ratio uses the market capitalization and divides it by the sales to form the P/S multiple. Instead of using the market-lead calculation of market capitalization, we can instead use enterprise value.

The ratio now becomes EV-to-sales (EV/S). Once again, this metric is

considered

more accurate by accounting for total debt and cash, whereas the market capitalization focused equation doesn’t.

Enterprise Value vs Other Metrics

Fortunately, there are many ratios to adequately measure valuations using enterprise value.

As mentioned, EV-to-sales (EV/S) is one way to go about valuation. The next couple are even more insightful. This includes EV/EBITDA and EV/EBIT. EBITDA, or otherwise known as earnings before interest, taxes, deductions, and amortization, is used to measure a company’s revenue generation capacity instead of net income, which is often oversimplified. Similarly, EBIT is yet another financial metric that can be used without the disadvantage of asset depreciation and expenses related to amortization.

EBITDA can be calculated using the following

formula

:

EBITDA = Earnings From Operations + Interest + Taxes + Depreciation + Amortization

To receive the sum of EBIT, simply use the same equation while excluding depreciation and amortization.

A more thorough explanation of EV/EBITDA and what it means can be found in this article. 

An Oversimplified Example

For the simplicity of this example, let’s use a market capitalization of $10 billion, total debt of $5 billion, and cash of $1 billion. In this equation, the enterprise value of the company is $14 billion.

With this information, we can now form accurate EV-based multiples. For instance, if the company generated $750 million in EBITDA, we could find the EV/EBITDA multiple by simply dividing the EV by EBITDA. This would result in a multiple of 18.6, which can be excellent or terrible

depending on the industry.

If it were a technology software company trading at an 18.6 EV/EBITDA multiple, this would be a bargain. On the other hand, if it was a general retail company, this would indicate an expensive price. 

The Pros and Cons of EV

First off, investors must recognize that the positives of using enterprise value over traditional market value is abundant. A more accurate picture can be formed about a company’s financial health by using similar ratios that substitute market value such as EV/S, EV/EBITDA, and EV/EBIT.

However, there are also some downsides. Since EV utilizes debt in the equation it’s important to know how this debt is being utilized and managed by the company. The problem is, this financial metric doesn’t answer either of those questions.

Where the real problems begin is when an investor is analyzing a capital intensive industry. Take manufacturing for an example, the EV would be disportionately high because of the capital required to fund operations. In this case, it may mislead investors and cause a missed opportunity. No matter which financial metric is used, it is always recommended to use the industry average multiple for any given company to form a more accurate conclusion.

Final Thoughts

Enterprise value is one of the most important metrics to know when establishing whether or not a company is overvalued. The added information such as total debt and cash being included provides far more insight to the financial health of the company.

Understanding how enterprise value works and how it can be used to find sales and EBITDA multiples can further assist an investor in their evaluation. Each financial metric contains information that is easily accessible, making it a compelling choice over price-oriented ratios such as price-to-earnings, sales, and more.

With that being said, it’s always best to use industry average multiples to evaluate if an equity is overvalued. This is because enterprise value may disportionately measure some companies with high costs of capital, such as manufacturing, oil and gas, and more.

Overall, there are compelling reasons to regularly utilize enterprise value when searching for underpriced equities.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

Original: Investing Feed: What is Enterprise Value? | Nasdaq