When a prospective buyer starts kicking tires on new companies to acquire, the conventional wisdom is to use traditional forms of value assessment, like market capitalization, to take the financial temperature of a company before deciding to buy it or not.
Yet the fact is, calculation models that use market capitalization or equity value miss the point when valuing the total cost of a company. While those models are certainly helpful, they only provide the value of a company in an incomplete fashion, missing the goal of any company acquisition vetting process - getting the total value and the total cost of paying the minimum amount of money to buy a company.
That's where enterprise value can fill in the gaps and get investors the true cost of a targeted company. It does so primarily by factoring in key corporate financial metrics that traditional company valuations do not.
What is enterprise value and how does it work? Read on, and get to know a better way to ascertain the true cost of buying a company - and learn how to pay the minimum possible price to buy that company.
What Is Enterprise Value?
Enterprise value is essentially a financial estimate of what a company is worth, if it were to be acquired.
Enterprise value is often viewed by financial specialists as an alternative method of valuing a company, as it factors in an equation that other calculations don't - the purchasing company's ability to pay off any debts on the company it's buying while collecting any cash or cash equivalents of the company it's buying.
Put another way, enterprise value is the estimated value, expressed in dollars, of the total value of a given company. Enterprise value bypasses traditional company value calculations, like market capitalization, to provide the aggregate value of a company (expressed as an enterprise.)
Enterprise value applies mostly for public companies, although the enterprise value calculation value would lead to a different purchase outcome if you were purchasing a public or private company.
Public companies. Investors using enterprise value to weigh the value of a publicly-traded company would have to purchase 100% of the company's stock to fully purchase the company.
Private companies. By and large, an enterprise value estimate would lead a buyer to pay cash or other financial assets to buy a privately-held company.
That stated, enterprise value is usually used to measure the value of a publicly-traded company.
Enterprise Value Versus Market Capitalization
There is some discussion among financial analysts on whether enterprise value or market capitalization is a better indicator of a company's value.
Yet the choice of using enterprise value over market capitalization isn't all that controversial, as the former uses more thorough and explicit factors to arrive at a company value estimate.
That's because enterprise value includes key financial factors like debt (especially in the form of loans and corporate bonds issued) and preferred stock. Additionally, enterprise value removes a company's cash reserves from its calculation, which a market capitalization calculation doesn't do.
(Basically, a market capitalization calculation would involve the number of a company's share outstanding multiplied by the stock's up to date share price.)
Think of the enterprise value versus market capitalization date this way:
A publicly traded company has 100 shares and each sells for $10. Thus, the market capitalization is $1,000.
That figure is the amount of money it would take - $1,000 - to buy every share of that publicly traded company.
In that context, market capitalization is valuable in estimating the price of a company - but not its value, as enterprise value aims to accomplish - the absolute minimum amount of money needed to buy a company in total.
How Do You Calculate Enterprise Value?
The calculation used to arrive at a company's enterprise value is as follows:
Start by adding up the company market capitalization number, its preferred stock, and total outstanding debt. Take the resulting number and subtract out any cash reported on the company's financial balance sheet.
Or, expressed this way, enterprise value calculation can be explained as follows:
Enterprise Value (EV) = Market Capitalization + Total Debt - Cash
The goal of any enterprise value calculation is to figure out what it would take, dollar-wise, to purchase 100% of a company's total stock, including.
Common stock. Common stock represents ownership of a publicly-traded company, expressed as a share or shares (security) of common stock.
Preferred stock. Preferred stock is a higher grade of publicly-traded stock that gives the stockholder the right to a fixed dividend payment, and whose payment is prioritized over common stockholders at the same company.
Outstanding debt. A company's outstanding debt is the total principal and interest owed on any debts taken out by a company (such as a bank loan or a corporate bond issuance.)
Once you've added up the above three financial figures and subtract cash and cash equivalents from a company's balance sheet, you've arrived at that company's total enterprise value.
That figure represents what it would take, expressed in dollars, to buy complete ownership of a publicly-traded company.
Why Use Enterprise Value to Buy a Company?
The main reason to use enterprise value is to acquire companies with robust cash levels and minimal debt. In that regard, enterprise value is the key to deciphering a company's cash-to-debt ratio, using the calculation listed above.
Make no mistake, cash and debt play a huge role in any estimate of a company's total value. For example, two firms with the exact same market cap might have very different enterprise values.
Consider this example - a business that posts a $45 million market capitalization, no debt, and $12 million in cash is less expensive to buy than the same $50 million company with $28 million of debt and no cash. Enterprise value, applied correctly, can help a buyer break costs estimates down that go way beyond market capitalization.
But the reasons for using enterprise value go deeper than that.
In broader terms, the fact that enterprise value allows you to gauge the total cost of buying a company, and not just a percentage of that company as stock investors do, is a big benefit.
After all, any company investors want to know the total value of the company they're buying, including its debt, assets, and the value of its products and services.
With enterprise planning, you're getting the best of both worlds, as enterprise value is highly helpful in ascertaining the market capitalization and the debt (liabilities) of a company under consideration for acquisition.
Factoring in the impact of liabilities of debts and the benefits of cash on hand also paints a more complete picture of a company's value, expressed by enterprise value.
Through that prism, enterprise value is basically the Swiss army knife of company value calculations, and is becoming widely used as a total cost evaluation model for acquiring companies and investors.
An Enterprise Value Example
In a real-world view, an acquiring company would use enterprise value to buy a company, using the equity value of that company, plus any net debt.
Enterprise value (EV) = Equity value (QV) + Net debt (ND)
To provide more clarity, let's say you're not buying a company, but a piece of commercial property - say a building downtown.
The total cost of the building equals $1 million. The total value of the building is also $1 million.
You finance the purchase by borrowing $800,000 from a bank, and put down $200,000 of your own money. Once the purchase is completed, you can say the enterprise value of your new commercial building is $1 million, while your equity value in the property is $200,000.
The enterprise value becomes the combined total of the investment in the building - the bank loan plus your personal down payment, i.e. the debt financed by the bank lender plus the equity provided by you, the buyer.
Note the enterprise value of your new downtown building doesn't change if you opt to add another $100,000 in personal funding, bringing your total down payment to $300,000 and the bank loan amount to $700,000.
While the equity value changes (by adding another $100,000 in personal funds) the enterprise value of the building purchase remains the same.
Or, in another example of enterprise value, you're buying a publicly-traded company, as follows:
The company to be purchased has the following financial data sets:
- It has $2 million shares outstanding
- Those shares are currently trading at $10 per share
- The total cash value of the company is $1 million, while its total debt is $200,000
- Using the enterprise value calculation is $2 million times 10, plus $200,000 minus $1 million.
That leads to an enterprise value estimate of $19,200,00.
The Takeaway on Enterprise Value
For companies and investors looking to acquire or take over a company, enterprise value offers a useful tool in gauging the targeted company's value, and calculating what it might take, at a minimum cost, to buy the company.
Thus, acquiring companies benefit in two ways by applying enterprise valuations to a company analysis:
- It calculates what it would take, dollar-wise, to buy up 100% of a company.
- It offers a capital neutral outlook on the targeted company, relative to other companies the buyer may be contemplating.
Taken together, those are valuable estimates any investor can use to make the right call in buying up a company - with a complete look at the entire cost of buying an entire company - or not buying it.
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