How to evaluate a company: What is Enterprise Value?
Enterprise value is the total value of a company’s income producing assets. This is defined by the following equation:
Enterprise Value = Market Value of Equity (a.k.a shares) + Market Value of Debt – Cash
Where did we get this from?!
Don’t worry – we’ve got you covered.
If you think about what exactly a company is for a minute, you might agree that we can think of it as a “black box” which contains a number of assets.
Some of these assets produce an income, and some of the assets don’t do much, just held in a bank account in the form of cash. We can write this as:
1) Assets which produce an income + Cash = Total Assets
Next, we know a company’s Total Assets are owned – or claimed by – equity and debt holders (a.k.a. shareholders and lenders). Take a second to reflect here – this link is important. We can then put these concepts together to come up with the following:
2) Total Assets = Equity Value + Value of Debt Outstanding
Swapping the definition of Total Assets from equation 1) into equation 2), we get:
3) Assets which produce an income + Cash = Equity Value + Debt Outstanding
We can rearrange equation 3) to give:
4) Assets which produce an income = Equity Value + Debt Outstanding – Cash
Next, Enterprise Value by definition is the total value of a company’s income producing assets, so we can re-name the first half of equation 4) to give:
5) Enterprise Value = Equity Value + Debt Outstanding – Cash
Finally, we know the equity value of a company is equal to its market value, or market cap in most cases. And we also know a company’s Debt Outstanding has a market value which is determined by the price at which its bonds and other loans are trading / valued at. So we can put these things together to come up with the final equation:
6) Enterprise Value = Market Value of Equity + Market Value of Debt – Cash
Why is Enterprise Value important?
Whereas looking at the share price and market cap of a company can give you its equity value, looking at Enterprise Value is a way of looking at the value of the whole company, which can give you an idea of how much its income producing assets are worth.
This is especially relevant when you are looking at companies which have materially different levels of debt. For example, if you compared “TinyCo” with a $100 market cap to “HugeCo” with a $200 market cap, you might conclude HugeCo is the bigger company. But this would be wrong if “TinyCo” had $200 of net debt outstanding while “HugeCo” had none. In this case, TinyCo’s Enterprise Value would be $300 whereas HugeCo’s Enterprise Value would be $200 – TinyCo would actually be the larger company.
Enterprise Value is also relevant for takeovers and acquisitions. If you are looking to buy a company in whole, you would need to determine its overall value in order to decide what to pay for it – not just the value of its equity.
This is all great to know, but for us individual investors, Enterprise Value – or “EV” – is useful to understand as it allows us to assess more valuation ratios in addition to something like the P/E ratio.
• We can use metrics such as EV/EBIT for example when we want to compare companies which have very different amounts of debt outstanding and/or are subject to different levels of taxation.
• Or we can look at EV/EBITDA for the same reasons as EV/EBIT but where we also want to take out management accounting decisions around Depreciation and Amortization.
• We can also compare companies based on EV/Revenue multiples – something often used for high growth, but loss generating, startups.
Enterprise Value is therefore an important metric to be familiar with if you want to look at company valuations as part of your investment decision making process!
Author: Harsh Patel, Evarvest. The article first appeared here.