A method of company valuation
A method of company valuation
Enterprise Value (EV) is a measure of a company’s total value. It looks at the entire market value rather than just the equity value, so all ownership interests and assets claims from both debt and equity are included. EV can be thought of as the effective cost of buying a company or the theoretical price of a target company. We calculate EV as follows:
EV = Equity Value (Market Cap) + Total Debt + Preferred Stock + Noncontrolling Interest – Cash and Cash Equivalents
The value of the company can be derived by the assets it owns. However, obtaining the market value of each and every asset can be quite tedious and difficult. What we could do instead is look at how the assets have been paid for. The simple accounting equation can serve as a guide by looking at assets as the application of funds and both liabilities and shareholder’s equity as the sources of funds used to finance those assets. When we say value, we mean the current or market value of the company, so it’s the market value of liabilities and the market value of equity that we consider.
Equity value is found by taking the company’s fully-diluted shares outstanding and multiplying it by stock’s current market price. Fully-diluted means that it includes in-the-money options, warrants and convertible securities aside from just the basic shares outstanding. If a company plans to acquire another company, it will need to pay that company’s shareholders by paying at least the market cap value. This alone is not considered an accurate measure of a company’s true value and for that reason; other items are added to it as seen in the EV equation.
Total debt is the contribution of banks and other creditors. They are interest-bearing liabilities and comprise short-term and long-term debt. The amount of debt gets adjusted by subtracting cash from it, because in theory, when a company has been acquired, the acquirer can use the target company’s cash to pay a portion of the assumed debt. If the market value of debt is unknown, the book value of debt can be used instead.
Preferred stocks are hybrid securities that have both features of equity and debt. They are treated more as debt in this case because they pay a fixed amount of dividends and have a higher priority in asset and earning claims than common stock. In an acquisition, they normally must be repaid just like debt.
Noncontrolling interest is a non-majority but significant ownership stake in another company (subsidiary). This portion of the subsidiary’s stock is not owned by the parent company. We add this to the calculation of EV because the parent company, owning more than 50% of the subsidiary, has consolidated financial statements with that company. By including the minority interest, the total value of the subsidiary is reflected in EV.
Cash and Cash Equivalents
This is the most liquid asset in a company’s statement. Examples of cash equivalents are short-term investments, marketable securities, commercial paper and money market funds. We subtract this amount from EV because it will reduce the acquiring costs of the target company. It is assumed that the acquirer will use the cash immediately to pay off a portion of the theoretical takeover price. Specifically, it would be immediately used to pay a dividend or buy back debt.
EV is often used for multiples such as EV/EBITDA, EV/EBIT, EV/FCF or EV/Sales for comparable analysis such as trading comps. Other formulas such as the P/E ratio usually don’t take cash and debt into account like how EV does. Hence, two identical companies that have the same market cap may have two different enterprise values.
For instance, Company A has $60 million in market cap, $20 million in cash and carries no debt. Company B, on the other hand, also has $60 million in market cap, but has no cash and carries $30 million of debt. In this simple scenario, we can see that Company A is cheaper to buy because it doesn’t have any debt to pay off creditors.
EV is very useful in Mergers and Acquisition situations, especially with controlling ownership interests. In addition, it is useful for comparing companies with different capital structures because a change in capital structure will not affect the amount of enterprise value.