Enterprise value or Firm Value considers much more than just the value of a company’s outstanding equity. It tells you how much a business is worth. Enterprise value is the theoretical price an acquirer might pay for another firm, and is useful in comparing firms with different capital structures since the value of a firm is unaffected by its choice of capital structure.
Apple’s EV has steadily increased in the past. However, Apple is now struggling to continue with their upward momentum and has been facing challenges for the past 2 years
In this article, we look at EV in detail –
- What is Enterprise Value?
- Enterprise Value Calculation
- Why use EV or Firm Value?
- Enterprise Value Example
- Siemens AG Acquisition of MENT – Enterprise Value Example
- EV multiples
- EV – Why it may not be same for everyone?
What is Enterprise Value (Firm Value)?
Enterprise value Definition – Enterprise Value is equal to the market capitalization plus debt plus value of minority interest plus value of preferred shares, minus total cash and cash equivalents. Thus, Enterprise Value formula is very simple:
Enterprise Value Formula = (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 associate 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, they have to be added.
Similarly, Enterprise Value Formula also includes other components such as employee stock options, abandonment provisions, environmental provisions and so on, because they also reflect claims on the company.
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 form:
Enterprise Value Formula= Market Capitalization + Market value of debt – Cash and cash equivalents
Looking at the above Enterprise Value Formula it can be understood that Firm Value is in fact obtained by the refinement of the Market Capitalization.
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 Calculation
The major terms used in Enterprise Value Calculation of a company are Market Capitalization, preferred equity, debt, Cash and cash equivalents and Minority interest. So let’s try to understand these terms in a bit of detail with examples
Step #1 – Enterprise Value Calculation – Market Capitalization:
It is the market value of common shares of a company which equals to 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
Step #2 – Enterprise Value Calculation – Debt:
It comprises the bonds and bank loans. Items such as trade creditors are not included in 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 business which is why they are added to the Enterprise Value calculation. For example, Johnson & Johnson has a total debt of $26,865 mn.
Step #3 – Enterprise Value Calculation – Preferred Shares:
They include redeemable preferred shares. They take priority over the ordinary shares 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 a preference shares of $22,273 mn.
Step #4 – Enterprise Value Calculation – 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 Interest 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.
Step #5 – Enterprise Value Calculation – Cash and Cash Equivalents
Cash and Cash Equivalents is very well known. It includes cash in hand, cash at bank, plus the 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 – all in one
Once we have populated all the required data in the excel sheet, we can calculate Enterprise value using the enterprise value formula
Enterprise Value Formula = (Market Cap + Debt + Preferred equity + Minority interest) – Cash and cash equivalents
Enterprise Value Formula for Verizon = $201,752.6 + $116,218 + 0 + $1,414 – $4,470 = $314,915 mn
Why use Enterprise Value or Firm 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 valuation, accounting, portfolio analysis, 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 especially because it also takes the other major 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 company, the acquirer will become the owner of the debt liabilities too. So whatever be the short term and long term debt and interest payments come due in 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 debt or 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 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 Enterprise Value 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.
Enterprise Value example – Siemens AG Acquisition of MENT
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 an 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.
Once you know how to calculate Enterprise value, it can be used to derive some vital multiples called Enterprise Multiples. EV multiples are used very often in Equity Research and Investment Banking domain for performing Relative Valuations.
- Enterprise Multiples are based on the relation between the value of a company in terms of the market value of its total capital from all sources and the operating earnings, generally taken as EBITDA. The EV/EBITDA multiple has a positive correlation with the increase in free cash flow to the firm (FCFF) and a negative correlation with the risk level and the weighted average cost of capital (WACC).
- This multiple is more useful than the PE ratio if firms with different degrees of financial leverage (DFL) have to be compared.
- Other relative valuation multiples containing the EV (Firm value) are EV/EBIT and EV/Sales. EV also includes the effect of the liquid assets and the value of debt a company has. Hence, the EV/Sales multiple serves a better purpose than does the Price/Sales ratio.
Also, checkout Enterprise Value vs Equity Value
EV – Why it may not be same for everyone?
If the enterprise value calculation is as simple as substituting the values in a given Enterprise Value Formula, why do two different persons get a different EV for the same company?
Look! Market Capitalization is easy to calculate. So both of them will get exactly 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 certain 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. Rather, 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? It needs the adjustments and subjective estimations I was talking about in the above paragraph.
Further, the important data like cash balances, debt level 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 too 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.
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 extremely useful to make investment decisions for retail investors as well as buyers of controlling interests. It is also used to compare a number of companies with diverse capital structures since it is a capital-neutral metric.
There are some very useful 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.
This has been a guide to what is Enterprise Value? We discuss Enterprise value formula, calculation along with practical examples, EV multiples as well as why EV is useful? You may also have a look at these articles below to learn more about valuations –