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Enterprise value is one of the vital concepts in corporate valuation. It serves as a foundation for several Merger & Acquisition deals. There are several reasons why entities prefer enterprise value over other forms of valuation. To understand them easily, one needs to become familiar with all the fundamental aspects of EV first.

What is Enterprise Value?

Enterprise Value meaning can be described as the measure of a firm’s total value and factors in the entire market value instead of the equity value. It directly ensures that all asset claims and ownership interests arising from debt and equity are included in the valuation.

EV is considered to be an actual cost of purchasing a company or the theoretical price of a company before a takeover is considered. In fact, it is the minimum value that an entity would pay to purchase a company.

Components of Enterprise Value

The major components of enterprise value are as follow –

1. Equity value

The equity value of a company is generally determined by multiplying its fully-diluted shares outstanding with the current market price of a stock. Here, fully-diluted means they are inclusive of warrants and convertible securities besides basic shares outstanding.

In the event of a company acquisition, the acquirer needs to pay the company’s shareholders at least the market capitalisation value. This alone is not deemed enough to provide a company’s accurate value; as a result, other items are added in the EV equation.

2. Preferred stock

Being hybrid securities, these stocks have features of both debt and equity. Regardless, preferred stocks are treated more like debt as a component in EV. It is primarily because they pay out a fixed amount of dividend and are given more priority in terms of assets and earnings than common stocks. In case of an acquisition, they are paid off like debt.

3. Total debt

It can be described as the contribution made towards financial institutions and creditors. They make up the interest-bearing liabilities and include short-term and long-term debt. The debt value is adjusted by simply deducting cash because when a company is acquired, acquirers use the company’s cash to pay off a share of assumed debt. The book value of debt is used in the case where its market value is unknown.

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4. Non-controlling interest (minority interest)

It is a part of a subsidiary which is not owned by any parent company. Typically, the financial statements of such a subsidiary are consolidated with the financial report of their parent company.

Generally, the minority interest is added in the calculation of EV because the parent company includes the total revenue earned, expenses incurred and cash flow generated in its financial numbers.

5. Cash and cash equivalents

These are among the most liquid assets in a company’s financial statement. Cash and cash equivalents like short-term investments, commercial paper, marketable securities, etc. are subtracted from EV. It is done because they tend to lower the acquiring cost of a company.

It is believed that the acquirer uses the cash to pay off at least some portion of the theoretical price or to pay for buyback debt.

Enterprise Value Formula and Calculation

There are two types of enterprise value formula, and they are as follow –

  • Simple formula for EV

EV = Market Capitalisation + Market Value of Debt – Cash and Equivalents

  • Extended formula for EV

EV = Common Shares + Preferred Shares + Market Value of Debt + Minority Interest – Cash and Equivalents

One can determine the market capitalisation of a company by multiplying its number of outstanding shares with its current stock price. Subsequently, all debt reported on the company’s balance sheet, including long-term and short-term debt, are added up. Lastly, the market capitalisation is added to the total debt, and total cash and cash equivalents are subtracted from the outcome.

Example of enterprise value calculation: A quick look at this table below can effectively help to understand how enterprise value is calculated.

ParticularsAmount (Rs.)
CMP94
Equity474
Face value20
Number of shares236
Market capitalisation22865
The market value of common stocks (A)22865
The market value of common stocks (B)0
Debt calculation 
Short-term borrowing1420
Long-term borrowing
Total Debt(C)1420
Minority Interest (D)0
Cash and investments (E)50

With the help of the above information,

EV Common Shares + Preferred Shares + Market Value of Debt + Minority Interest – Cash and Equivalents

 = Market value of common stock + Market value of common stock + Total Debt + Minority Interest – Cash and investments

= Rs.24235

Enterprise Value and Valuation Multiple

Here are the most important multiples of EV –

  • EV/EBITDA 

Here,

EBITDA = Earnings from continuing operations + Interest + Taxes + Amortisation + Depreciation

The said EV multiple proves useful in these following ways –

  • It helps to value capital intensive business ventures.
  • Facilitates effective comparison of firms, even when they have different financial leverages.
  • Helps to compare companies with different capital structures more effectively.
  • It proves more useful in the valuation of capital-intensive business ventures which accompany high levels of depreciation and amortisation.
  • EV/ Sales

It is a preferred ratio, which accounts for the debt portion which needs to be paid off. The lower this ratio, the more undervalued is a company under the scanner.

Significance of Enterprise Value

These pointers below highlight the significance of enterprise value –

  • EV enables business entities to find out the worth of a target company.
  • It signifies the economic value of a business firm in question.
  • It is more like the theoretical takeover price of a company in question and accounts for the cash and debt that will be pocketed by the acquirer.
  • Enterprise value makes it possible to compare companies of different capital structures with greater ease.
  • It comes in handy to neutralise the stock market risk and helps to compare expected returns more effectively.

Notably, market capitalisation is a vital component of EV. Still, it may prove to be of limited utility for companies that are not listed and whose shares are quoted at face value. Likewise, in the case of public listed companies with a limited float, whose share prices can be manipulated to show a higher value, the above-mentioned component may fall short.

Business entities need to factor in financial metrics like cash flow, debt level, asset replacement to achieve more accurate valuation. Also, business entities should consider comparing companies functioning within the same industry to avail more accurate and relevant results.

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