Enterprise Value (EV)

What is Enterprise Value?

Enterprise Value is a measure of the total value of the company and provides an overview of the entire market rather than just the equity value, it covers all the ownership claims from debt and equity, this ratio is particularly important to value a takeover and is calculated as the market value of debt plus market value of equity minus the cash and cash equivalents.

Formula Explained

Enterprise Value (EV) = (Market Capitalization + Market value of preferred equity + Market value of debt + Minority interest) – Cash and cash equivalents

Sometimes the acquired company may also have certain associated companies whose value might also have to be subtracted to obtain the Firm Value. Also, if there are unfunded pension liabilities on the acquired company’s balance sheet Balance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more, they have to be added.

Similarly, Enterprise Value FormulaEnterprise Value FormulaThe Enterprise Value Formula is an economic measure that reflects the entire value of the organization, including secured and unsecured creditors, equity and preference shareholders, and is more commonly employed in acquiring other businesses or merging two or more businesses to achieve synergy. Enterprise value Formula = Market Capitalization + Preferred stock + Outstanding Debt + Minority Interest – Cash & Cash Equivalentsread more also includes other common ones.

Many times, the value of minority interest and that of preferred equity are not material or are equal to zero for the company. This is because they are simply absent. In that case, the above Enterprise Value Formula takes the following simpler forms, such as employee stock options, abandonment provisions, environmental provisions, and so on, because they also reflect claims on the company.

Apple-Enterprise-Value

Enterprise Value (EV) = Market Capitalization + Market value of debt – Cash and cash equivalents

Looking at the above formula, it can be understood that Firm Value is, in fact, obtained by the refinement of the Market Capitalization.

enterprise value

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For eg:
Source: Enterprise Value (EV) (wallstreetmojo.com)

Market capitalization is simply the share price of the stock of the company multiplied by the total number of shares outstanding. On the other hand, EV has those additional terms shown above, which result in a figure which can serve the purpose of an investor more fruitfully.

Learn more about “Enterprise Value vs. Market Capitalization”

Enterprise Value of a Company

The major terms used in EV Calculation of a company are Market Capitalization, preferred equity, debt, cash and cash equivalentsCash And Cash EquivalentsCash and Cash Equivalents are assets that are short-term and highly liquid investments that can be readily converted into cash and have a low risk of price fluctuation.  Cash and paper money, US Treasury bills, undeposited receipts, and Money Market funds are its examples. They are normally found as a line item on the top of the balance sheet asset. read more, and Minority interestMinority InterestMinority interest is the investors' stakeholding that is less than 50% of the existing shares or the voting rights in the company. The minority shareholders do not have control over the company through their voting rights, thereby having a meagre role in the corporate decision-making.read more. So let’s try to understand these terms in a bit of detail with examples.

Step #1 – Calculate Market Capitalization:

It is the market value of common shares of a company, which equals the product of the number of shares (common equity) and the current market price per share.

In the example below, we have top listed companies along with the Price and Shares Outstanding.

  • Market Capitalization = Price x Shares Oustanding.
  • Amazon.com Market Cap = 785.33 x 475.2 = $373,162.5 million
market-cap

source: ycharts

Step #2 – Calculate Debt

It comprises bonds and bank loans. Items such as trade creditTrade CreditThe term "trade credit" refers to credit provided by a supplier to a buyer of goods or services. This makes it is possible to buy goods or services from a supplier on credit rather than paying cash up front.read more are not included in the debt. Once a company is acquired, these debts become the responsibility of the acquirer. The acquirer becomes liable to repay the debts from the cash flows of the businessCash Flows Of The BusinessCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more, which is why they are added to the Enterprise Value calculation. For example, Johnson & Johnson has a total debt of $26,865 mn.-debt

source: ycharts

Step #3 – Calculate Preferred Shares:

They include redeemable preferred shares. They take priority over the ordinary sharesThey Take Priority Over The Ordinary SharesOrdinary Shares are the shares that are issued by the company for the purpose of raising the funds from the public and the private sources for its working. Such shares carry voting rights and are shown under owner’s equity in the liability side of the balance sheet of the company.read more and hence are effectively similar to debt. This is why preferred shares represent a claim on the business that must be taken in Enterprise Value Calculation.

As you may note that not many companies have preference shares. Bank of America has preference shares of $22,273 mn.

prefrred-shares

Step #4 – Find the Minority Interest:

It is actually the proportion of subsidiaries owned by minority shareholders. Thus, it should be treated as a non-current liability.

Like Preference Shares, Minority InterestMinority InterestMinority interest is the investors' stakeholding that is less than 50% of the existing shares or the voting rights in the company. The minority shareholders do not have control over the company through their voting rights, thereby having a meagre role in the corporate decision-making.read more is most likely to be missing from the balance sheet or is generally a small number to consider. For example, AT&T has a minority interest of $969mn.

minority-interest

Step #5 – Find Cash and Cash Equivalents

Cash and Cash EquivalentsCash And Cash EquivalentsCash and Cash Equivalents are assets that are short-term and highly liquid investments that can be readily converted into cash and have a low risk of price fluctuation.  Cash and paper money, US Treasury bills, undeposited receipts, and Money Market funds are its examples. They are normally found as a line item on the top of the balance sheet asset. read more are very well known. It includes cash in hand, cash at the bank, plus short-term investments. Most of the highly liquid assets are considered equivalent to cash because they are readily convertible to cash. Since they reduce the acquisition price in effect, they are subtracted for the calculation of enterprise value.

Alphabet (Google) has a cash and cash equivalents of $16,549mn.

enterprise-value-calculation-cash-cash-equivalents

Enterprise Value Calculation – all in one

Once we have populated all the required data in the excel sheet, we can calculate Enterprise value using the formula.

EV Formula = (Market Cap + Debt + Preferred equity + Minority interest) – Cash and cash equivalents

EV Formula for Verizon = $201,752.6 + $116,218 + 0 + $1,414 – $4,470 = $314,915 mn 

enterprise-value-calculation

Why use Enterprise Value?

Firm value can be seen as the theoretical takeover price if the company was to be acquired by another company. This price can be considered as acceptable to the buyer as well as the seller when they sit to negotiate the acquisition.

Ev is an extremely vital metric used for the purposes of business valuation, financial modeling and valuationFinancial Modeling And ValuationFinancial modeling refers to the use of excel-based models to reflect a company's projected financial performance. Such models represent the financial situation by taking into account risks and future assumptions, which are critical for making significant decisions in the future, such as raising capital or valuing a business, and interpreting their impact.read more, accounting, portfolio analysisPortfolio AnalysisPortfolio analysis is one of the areas of investment management that enables market participants to analyze and assess the performance of a portfolio to measure performance on a relative and absolute basis along with its associated risks.read more, and risk analysis. Firm value is also accepted by one and all as a more accurate representation of the value of a company than simple market capitalization.

This is mainly because it also takes the other significant implications into account that the acquirer will have to deal with as the new owner of the acquired company. The following two paragraphs will easily make you understand this concept.

With all the current and non-current assets of the companyNon-current Assets Of The CompanyNon-current assets are long-term assets bought to use in the business, and their benefits are likely to accrue for many years. These Assets reveal information about the company's investing activities and can be tangible or intangible. Examples include property, plant, equipment, land & building, bonds and stocks, patents, trademark.read more, the acquirer will become the owner of the debt liabilities too. So whatever be the short term and long term debtLong Term DebtLong-term debt is the debt taken by the company that gets due or is payable after one year on the date of the balance sheet. It is recorded on the liabilities side of the company's balance sheet as the non-current liability.read more and interest payments come due in the future, they will add to the cost of acquisition incurred by the acquirer.

Similarly, all the cash on the balance sheet of the acquired company will also then go to the hands of the acquirer company. So the acquirer company can use that cash to pay out the debtorDebtorA debtor is a person or entity that owes money to the other party in a transaction. The receiver is referred to as the creditor, and the payment terms vary for each transaction based on the terms and conditions agreed upon by the parties.read more to meet any other liabilities of the company. So the amount of cash present on the acquired company’s balance sheet needs to be subtracted in order to arrive at the correct theoretical value of the company.

The above two paragraphs clearly explain why all the debt gets added to while all the cash and cash equivalents get subtracted from the Market Capitalization value while we do the Enterprise value Calculation.

Enterprise Value Example – Basic Case Study

Suppose a company ABC is considering the acquisition of another company XYZ. Now, what amount to be paid should ABC have in mind for this purpose? Or, what is the Enterprise Value / Firm value of XYZ if it has the following financial details?

  • Shares outstanding = 1,000,000
  • Stock price = $ 20 per share
  • Market value of debt = $ 10,000,000
  • Cash and cash equivalents = $ 8,000,000
  • Market value of preferred equity = $ 500,000
  • Minority interest = $ 2,000,000

The Market Capitalization will be equal to (Shares outstanding * Stock price) = (1,000,000 * $ 20) = $ 20,000,000.

Therefore, the calculation is done as follows:

Enterprise Value Formula = (Market Capitalization + Market value of preferred equity + Market value of debt + Minority interest) – Cash and cash equivalents

= ($ 20,000,000 + $ 500,000 + $ 10,000,000 + $ 2,000,000) – $ 8,000,000 = $ 24,500,000

This is the Firm value of the company XYZ and the same is that figure that the company ABC must keep in mind if it is thinking about taking over the company XYZ.

In the above example, the Firm value is 22.5 % higher than the Market Capitalization of XYZ. This means that if ABC buys XYZ, it will be paying a 22.5 % premium over the current stock price of XYZ. This implies that ABC will be paying $ 24.5 per share to buy XYZ, whose Stock price is $ 20 per share. This does happen in the real world as generally, the Firm Value of significantly a leveraged company comes out to be higher than its Market Cap.

Siemens AG Acquisition of MENT Example

Very recent takeover news floating on the Wall Street is that the German conglomerate, Siemens AG (SIEGY, SMAWF), is going to take over the design automation and industrial software provider Mentor Graphics Corp. ( MENT ) for $ 37.25 per share in cash, which represents a Firm value (EV) of $ 4.5 billion. This announcement was made on Monday, November 14, 2016.

Now, the stock price of Mentor Graphics Corp. would keep varying on the market. But the news article has stated that the offer price of $ 4.5 billion represents a 21 % premium to Mentor’s closing price on the last trading day prior to the announcement, i.e., November 11, 2016.

MENT-Enterprise-Value-v1

source: ycharts

EV Multiples

Once you know how to calculate Enterprise value, it can be used to derive some integral multiples called Enterprise Multiples. EV multiples are used very often in Equity ResearchEquity ResearchEquity Research refers to the study of a business, i.e., analyzing a company's financials, performing Ratio Analysis, Financial forecasting in Excel (Financial Modeling), & exploring scenarios to make insightful BUY/HOLD/SELL stock investment recommendations. Moreover, the Equity Research Analysts discuss their findings & details in the Equity Research Reports. read more and Investment Banking domain for performing Relative Valuations.

Also, check out Enterprise Value vs. Equity ValueEnterprise Value Vs. Equity ValueThe equity value is of two types: market equity value which is the total number of shares multiplied by market share price, and the book equity, which is the value of assets minus liabilities. In contrast, enterprise value is the total value of equity plus debt minus the company's amount of cash.read more.

EV – Why it may not be the same for everyone?

If the enterprise value calculation is as simple as substituting the values in a given formula, why do two different persons get another EV for the same company?

Look! Market Capitalization is easy to calculate. So both of them will get precisely the same value for that term. However, the other terms involved are not given as it is, in most cases, not even in the financial statements. They have to be derived and calculated and adjusted for specific reasons. Without such adjustments and even subjective estimations, it is virtually impossible to calculate Enterprise value (Firm value). And it is this place where the variation in the Enterprise Value calculation done by two different persons comes into the picture.

Take debt, for example. A large portion of the corporate debt is not publicly traded. Instead, most of it is in the form of bank financing, finance leases, and other forms of debt for which there is no market price. So how do you find that much needed “Market value of debt” term from the data given in the company’s financial statements Financial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more? It needs the adjustments and subjective estimations I was talking about in the above paragraph.

Further, essential data like cash balances, debt levels, and provisions are not published frequently (mostly once a year). So you need to project these values if you are assessing the EV (Firm value) of a company in the middle of a year (or any reporting period for that matter).

Similarly, Associates and Minority interests are reported at their historical values in the books. They don’t reflect their current “market value.” Also, unfunded pension liabilities involve various assumptions and do not represent a true “market” value. So, these two have to be estimated by making adjustments to their published values.

Sometimes, in many professional valuations, they take the above terms at the face values or book values as reported by the company. However, it is the accuracy in estimation of these terms only that marks the difference between a beginner and an expert at finding the EV.

Conclusion

Enterprise Value is a comprehensive measure of a company’s total value. It is a refinement of Market Capitalization and takes into account the claims by all claimants (creditors, both secured and unsecured as well as the shareholders, preferred and common, rather than just the market value of the equity.

It is beneficial to make investment decisions for retail investors as well as buyers of controlling interestsControlling InterestsA controlling interest is the shareholder's power to speak in the corporate actions or decisions derived from possessing a considerable chunk of the company's voting stock. However, such a stakeholder may or may not hold a significant portion of the company's common stocks.read more. It is also used to compare a number of companies with diverse capital structures since it is a capital-neutral metric.

There are some beneficial ratios that contain EV as a term. These ratios are also useful in the relative valuation of companies.

Finally, EV (Firm value) is not a value obtained by adding and subtracting certain given values. Most of the terms involved have to be derived by making adjustments and subjective estimations, which can cause the final value to vary from one analyst to another.

Enterprise Value Video

 

This article was a Guide to what is Enterprise value & its definition. Here we discuss why EV is useful for acquisition analysis and find EV for Apple, AT&T, Verizon, and more. You may also have a look at these articles below to learn more about valuations –

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Comments

  1. Yusuf Ibrahim says

    Many thanks Dheeraj. Awesome piece!

    • Dheeraj Vaidya says

      Thanks for your kind words!

  2. Nadine says

    Mr. Dheeraj,

    This post couldn’t come at a better time! I am currently at work trying to refresh my knowledge on EV, Relative Valuation, Comparables,etc. I stumble on to this and feel miraculously saved!

    Thank you so much for giving us access to important topics in such an easy, succinct manner!

    All the best,

    Nadine

    • Dheeraj Vaidya says

      thanks Nadine! I am glad that you found this useful.