If you’re interested in buying a company’s shares, then you will want to know the enterprise value (EV). It tells you how much the market values the company on the day of calculating the EV.
But to determine how profitable the investment will be, then you also consider the EV/EBITDA ratio. It’s a more reliable ratio for determining when to expect your ROI compared to the Profits-to-Earnings ratio.
This article will teach you how to calculate enterprise value, what it tells you, and its limitations.
Read through to the end because we’ll also introduce you to the EV/EBITDA ratio.
But first,
What is enterprise value?
Enterprise value refers to the overall market value of a firm. It is the minimum amount of money a party could pay to purchase a firm based on its assets.
While you could calculate a firm’s value by adding up the market value of each of the firm’s assets, the enterprise value is a more straightforward and equally accurate approach.
So, instead of looking at the assets, an analyst would look at how the assets were paid for.
Generally, the funding for a company’s assets comes from shareholders and lenders.
Therefore, to determine how much a company is worth, you’ll sum up the shareholders’ and lenders’ contributions.
But instead of adding the debt as is, you’d have to adjust the debt against any cash sitting in the balance sheet.
Why?
Let’s consider a firm with $505 million debt collected from lenders. And at the same time, the firm has $300 million cash.
If the firm wanted to, it could use the cash to pay part of the debt.
So, in theory, the firm has a net debt of $205 million ($505 million – $300 million).
The enterprise value is an accurate way to determine how much value an investor would place on a company at the date of calculating the EV.
But then the firm does not only collect money from the shareholders and lenders; it also makes a profit.
And that’s where the EV/EBITDA ratio comes in – more on this later.
Follow through to learn how to use various business data to determine a company’s market value, through easy-to-follow and straightforward procedures and formulas.
Let’s get into it.
How do you calculate enterprise value?
To calculate enterprise value, add the business’ market capitalization to the outstanding debt and subtract the cash and cash equivalents (CCEs).
Put in a formula:
Enterprise value = Market Capitalization + market value of debt- cash and cash equivalents.
Market capitalization (market cap) is the value of a firm’s total shares. It is calculated by multiplying the current price of a stock by the total number of outstanding shares.
The market value of debt is the total amount that investors are willing to pay to acquire a firm’s debt, which is not in line with the balance sheet value.
On the other hand, Cash and Cash Equivalent (CCES) refers to a company’s assets that are Cash or can be converted into cash immediately (Cash Equivalents).
To get the total value of the cash and cash equivalents (CCE), add the total amount of money a company has at hand and its cash equivalents.
CCE is the most liquid (readily usable) form of a company’s assets and is thus indicated at the top line item of a firm’s balance sheet.
In theory, the enterprise value is calculated as:
EV = Common stocks + Preferred stocks + Market Value of Debt + Minority Interest – Cash and Equivalents
But using the market value might prove to be a lot of effort.
So in practice, analysts use this simple formula:
EV = Market cap (No. of outstanding shares x share price) + Net debt (long-term + short-term debts – cash in the balance sheet)
Let’s explore these components.
The components of enterprise value
Market capitalization
Market cap refers to the total number of outstanding preferred and common shares. It is the value of equity contribution from shareholders.
How to calculate the market cap?
Multiply the total shares issued by the company by the share price.
For example, if a company has issued 5,500 million shares, and each share is worth $3, then the market cap is (5500 million x $3) = $16,500 million.
The market cap represents a firm’s funding from the stakeholders.
Total debt
Total debt makes up the interest-bearing liabilities and includes both the firm’s short-term and long-term debts. It is the contribution from the creditors and financial institutions.
Net debt refers to the total debt minus the cash and cash equivalents.
Cash and cash equivalents
As explained earlier, CCEs refer to the total value of assets that are cash and those that can be liquified immediately or on short notice.
They include treasury bills, treasury notes, commercial paper, cash management pools, certificates of deposit, and money market funds.
Non-controlling interest
Non-controlling interest, or minority interest, is the subsidiary owned by a shareholder who has no control over decisions and owns less than 50% of the total outstanding shares.
The company includes 100% of the revenue expenses and cash flows, even though it owns less than 100% of the subsidiaries.
Preferred stocks
Unlike common stocks, these are stocks that grant high-priority rights to shareholders. These stocks possess higher dividend payments and a higher claim to assets in liquidation.
Preferred stocks can be calculated as debt if they must be redeemed at a predetermined date and price.
Why is debt added to equity value?
Since debt holders possess a higher claim of the company’s assets and value than equity holders, debt has to be added to the company’s equity to get the enterprise value in case of liquidation.
Higher debts mean higher enterprise value since anyone who wants to buy a given firm has to clear its debts to own it fully.
How to calculate enterprise value (examples)
Below are different ways to calculate the enterprise value.
1. Calculating enterprise value from the balance sheet
To calculate the enterprise value from the balance sheet, sum up (the firm’s market capitalization, the outstanding debt, minority interest, and the preferred stock), and then subtract (the cash and the cash equivalents) on the balance sheet.
That is:
Enterpise value= Market Capitalization+ Outstanding debt + Minority Interest + Prefered Stock – Cash & Cash Equivalents.
- To find out the Market Capitalization, take the number of outstanding shares from the balance sheet and multiply it by the current price per share from the stock market.
I.e., Market cap = Total outstanding shares × Current price per share.
- To get the current outstanding debt balance, add short-term and long-term loans like bank loans.
- Read the minority interest as indicated on the balance sheet.
- For the value of the preferred stock, multiply the number of outstanding preference shares with the stock’s par value.
I.e., Preferred stock = Outstanding number of preference shares × Stock par value.
- Read the cash and cash equivalents from the balance sheet.
For example, if a company has the following financial information on the balance sheet:
- Outstanding shares: 5 million
- Current share price: $5
- Cash and cash equivalents: $3 million
- Total debt: $4 million
- Preferred stock: $0
- Minority interest: $0
Then,
Market capitalisation: 5 million × $5 = $25 million
And,
Enterprise value = $25 million + $4 million – $3 million + $0
= $26 million
2. How to calculate enterprise value from free cash flow
To calculate enterprise value from free cash flow, subtract the cost of maintaining the asset base (capital expenditure) from the total free cash flow before the interest payments to the debt holders.
Free cash flow refers to a firm’s money after clearing its operational and capital expenditures. The more free cash flow a company has, the more cash it has to pay back its stakeholders.
3. Calculating the enterprise value of a private company
There are several methods you can use to calculate the enterprise value of a private company.
These methods include:
- The comparable company analysis approach
- Estimatimating discounted cashflow
- Private equity evaluation metrics
The comparable company analysis approach
For this approach, you search for public companies within the same industry, age, size, and growth rate as the target firm, traded publicly within the recent future. You can check in your industry’s directory.
Once you’ve identified a few such companies, go ahead and calculate their enterprise values, EV/EBITDA, etc. Ensure that you use values from the last fiscal year for updated information.
If four similar companies have enterprise values between $100 million and $300 million, you can estimate that the private company’s enterprise value is within that range.
Using equity evaluation metrics
This method involves using a firm’s metrics such as price-to-earnings, price-to-cash flows, price-to-book, and price-to-sales to determine the enterprise value.
If the company you’re aiming for has gone through a recent merger or acquisition, you can use the information from the transaction to calculate the firm’s enterprise value.
Since the parties involved in the transaction will have laid out the enterprise value of the firm’s competitors, looking into the financial information they worked with could lead you to a more accurate valuation.
Estimatimating the discounted cash flow
To evaluate the enterprise value of the target firm, you study the discounted cash flow of other similar private companies within the same peer group as the target firm.
- For a start, calculate the average growth rate of the companies in the same peer group to establish the estimated revenue growth of the target firm.
- Gather information from companies with similar growth cycles and management principles as the firm you target, as these will give you more accurate data on the estimated revenue.
- With a revenue estimate, you can estimate the changes in operational costs in the target firm.
- You can then calculate the free cash flow, which will lead you to the operating cash after subtracting the capital expenditures.
Free Cash Flow = cash from operations – capital expenditure
The free cash flow helps determine the amount of money available to give back to the shareholders.
4. How to calculate enterprise value from market capitalization
Market capitalization refers to the value of all outstanding shares of a company’s stock — the share price multiplied by the number of outstanding shares.
To calculate the enterprise value from market capitalization, add its total debt (both short and long term) to its market cap, and then subtract the cash and cash equivalents.
5. Calculating enterprise value using DCF
Discounted Cash Flows (DCF) is a method of determining the value of a business by evaluating the company’s projected cash flows. The method aims at establishing the present value of a company based on the amount of money the firm is deemed to generate in the future.
To calculate a company’s enterprise value from the discounted cash flows, take the company’s forecasted cash flow over a set period and divide it by (1+r)＾n, where ‘r’ is the interest rate is, and ‘n’ is the set period in years.
Since inflation erodes money’s value over time, a dollar earned today is not equivalent to a dollar earned after two years. That’s because you can’t invest next year’s money today.
Therefore, the method stipulated above aims to reduce the company’s future earnings to be equivalent to today’s money, which is referred to as discounting.
For example, suppose the company generates annual revenue of 200 million and is estimated to generate the same revenue for the next six years, and the interest rate is at 10%.
In this case, you can calculate its enterprise value, by applying the above formula, that is:
Year 1= 200 million x 1/(1+10/100)
= 200 mil x 1/1.1 (or 200 mil ÷ 1.1)
=$181, 818, 181.8
Year 2= 200 mil x 1(1/1.1)^2
= $165, 289, 256.2
Year 3= 200 mil x (1/1.1)^3
= $150, 262, 960.2
Year 4= 200 mil x (1/1.1)^4
=$136, 602, 691.1
Year 5= 200 mil x (1/1.1)^5
=$124, 184, 264.6
Year 6= 200 mil x (1/1.1)^6
=$112, 894, 786
So the net present value of the 6 year cashflows in today’s money is;
= $181, 818,181.8 + $165, 289, 256.2 + $150, 262, 960.2 + $136, 602, 691.1 + $124, 184, 264.6 + $112, 894, 786
= $8, 7110, 521, 39.9
To calculate what each share would cost if the company issued, say 200 million shares, you divide this net resent value by the total shares.
= $8, 7110, 521, 39.9 ÷ 200 million
≈ $4.355
So, each share is worth ≈ $4.355
6. How you can calculate enterprise value in excel
When calculating enterprise value in excel, fill in the required information, i.e., market capitalization, outstanding debt, and cash and cash equivalents, in respective cells as shown in the example below.
Sum up the market capitalization and Market value debt values and subtract the cash and cash equivalents.
Let’s say a company XYZ has a market capitalization of $70,000,000, a Market value debt of $5,000,000, and a Cash and Cash equivalent value of $8,000,000.
Using the formula:
Enterprise value = market capitalization + market value of debt – cash and equivalents.
The enterprise value can be calculated as follows on Excel:
Therefore the enterprise value of company XYZ is $67,000,000
What does the enterprise value tell you?
- Enterprise value shows the total amount of money you would require to purchase a given company.
- An enterprise value gives you a more accurate reflection of a company’s value than market capitalization.
- Enterprise also helps in the comparison of different companies with diverse capital structures.
- An enterprise value helps investors determine whether a given company is undervalued or not. It is useful for calculating other ratios like EV/EBITDA, EV/Sales, and EV/Free Cash Flow for comparable analysis.
What is EV/EBITDA?
EV/EBITDA is a ratio of the enterprise value (EV) to the earnings before interest (on loans), taxes (corporate tax), depreciation and amortization (EBITDA). It’s ratio of a firm’s market value to the profits.
So it shows the profitability of the company. And therefore, it tells an investor whether a share is cheap or expensive.
Let’s consider a firm with an enterprise value of $700 million and EBITDA value of $100 million today
To calculate the EV/EBITDA ratio, we’ll divide EV by EBITDA.
EV/EBITDA = $700 million ÷ $100 million
= 7
So if you bought this firm’s shares today, you could expect your money back in 7 years.
EV/EBITDA is one of the most comprehensive and reliable ratios for determining a company’s profitability.
Compared to the Profit-to-Earnings ratio, the EV/EBITDA is more comprehensive because it includes the lender’s contribution.
It is also a more reliable figure for the profit because it considers the earnings before stripping out taxes.
However, you can’t rely on the EV/EBITDA alone to determine profitability.
What is a good enterprise value?
A good enterprise value (EV) is interpreted against the EBITDA. If the EV/EBITDA ratio is 10, then it implies that if an investor buys the company at the current share price, it’ll take about 10 years to get their money back. So, the lower the EV/EBITDA, the sweeter the investment.
Limitations of the enterprise value
Enterprise value includes a firm’s total debts. Thus, companies with huge debts appear to have higher enterprise value than those with little or no debts, even though they may be of similar size and stature.
When used in a sales firm to measure the firm’s worth, an enterprise value may be deceptive since a higher ratio may not necessarily signal an overvalued company.
A high enterprise value-to-sales ratio may signify investors’ positive belief in the company’s sales increase in the future.
