Enterprise Value : Formula & Significance

Enterprise Value is a business valuation calculation that measures the worth of a company by comparing its stock price, outstanding debt, and cash and equivalents in the event of a company sale. In other words, it’s a way to measure how much a purchasing company should pay to buy out another company. It is also called the takeover price because it is the amount of money required to purchase 100 percent of a business and thus take it over.

Detailed Review E Books by Yadnya

In business there are generally two ways to grow a company. Some companies grow internally by developing new products and lines to reach new customers. While this strategy is great, it can be slow and costly. Developing new products and marketing to new customers isn’t cheap. That’s why many companies choice a different growth strategy. They expand by acquisition. Rather than developing new products, they just find companies that are already successful in those spaces and purchase them. This is where business valuation methods are important.

Traditionally, the market capitalization is used to compute the value of company by multiplying the outstanding shares by the fair market value per share. This gives investors a good understanding of the company, but it doesn’t take into account other balance sheet items like debt and cash. On the other hand, Enterprise value considers the entire economic value of a company using these other accounts. That’s how to value a company the right way.

What is enterprise value?

What is Enterprise Value of a Company?
  • Enterprise value (EV) is an indicator of how the market attributes value to a firm as a whole. EV is a measure of a company’s total value, often used as a more comprehensive alternative to equity market capitalization.
  • EV of a company is the theoretical amount of money required to buy a company. It takes into account Market capitalisation of a company, debts of a company and its cash reserves.
  • To buy a company, all its stocks have to bought, all its debts would have to be taken over and cash reserves of the company can help in settling these debts if required. Cash reserves hence are deducted while calculating the take-over price of a company. While buying the company even the debt of the company would be the new owner’s liability and hence are added while calculating Enterprise value.
  • Enterprise value is more comprehensive than market capitalisation as it takes debt into account. EV provides a clear picture of the company as debt is added to and cash reserve subtracted from market capitalisation.

Formula of EV

EV = Market capitalization + Total Debt of the company – Cash & Cash Equivalents
Where,

  • Market capitalization = Current Stock Price * Total No. Of Outstanding Shares
  • Total Debt is equal to the sum of short-term and long-term debt. It is the amount of outstanding debt on the balance sheet of the company. Total debt is the amount of money owed to all banks, financial institutions and creditors.
  • Cash and cash equivalents are the highly liquid assets of a company, cash in hand, cash in company bank account

example 1

If a company ABC has the total number of share outstanding 4 lacs where its current market price is Rs. 100, the company has debt amounting to 50 lacs and has cash reserves of 60 lacs then, EV would be,

  • EV= Market Capitalization + Total Debt + Cash & Cash equivalents EV= 4,00,000*100 +  50,00,000 – 60,00,000 = Rs.3,90,00,000
  • Thus from this example, we can understand that EV is more comprehensive than market capitalization as Debts are taken into account.
  • It provides a clear picture of takeover price as debts are added and cash & cash equivalents are subtracted.

example 2

Latest figures of Enterprise Value and Market Capitalization of Reliance Industries, Tata Steel and HUL:

Latest EV and Market Cap of Reliance Industries, Tata Steel and HUL
  1. Reliance Industries:
  • Market Capitalization = Rs. 8,04,919 Cr
  • Enterprise Value = Rs. 10,20,297 Cr

2. Tata Steel

  • Market Capitalization = 62,699 Cr  
  • Enterprise Value = Rs. 86,128 Cr

One more interesting example, where EV < Market Cap

3. HUL

  • Market Capitalization = Rs. 3,68,719 Cr
  • Enterprise Value = Rs. 3,65,234 Cr
  • EV = Market Cap + Debt – Cash & Cash Equivalents
  • Here in HUL, Debt = 0 and
  • HUL has Cash & Cash Equivalents value= Market Cap – EV
  • Thus, Cash & Cash Equivalents value = 3,68,719 Cr – 3,65,234 Cr = 3,485 Cr
  • But here in case of HUL as it is a FMCG company, EV is no so important factor in zero debt or FMCG sector.
  1. Though EV is no so important factor in FMCG sector, if any Capital intensive company is having zero debt and is smoothly managing its working capital requirements through its cash & equivalents, then it would be definitely a commendable job.
  2. Therefore, capital intensive companies with zero debts are really creditable.
  3. For Example, in Auto industry, Bajaj Auto, Hero Motocorp. Though currently their stocks are not doing well and seem to be sluggish, but from the shareholder’s perspective, these stocks have created a massive wealth for their shareholders in last 3-4 decades and are zero debt companies.
  4. Also, in case of Maruti Suzuki, though the company has giant plants, is launching new cars persistently, still it is comfortably managing its capital requirement. It is really an admirable job.
  5. Therefore, while comparing the stocks of these capital intensive industries, Enterprise Value of company plays a very crucial role.

application of EV

  1. EV/EBITDA helpful than P/E ratio while comparing two firms with different financing structures. As EBITDA eliminates the impact of different financing structures utilized by the companies.
  2. EV/Sales ratio is a measure used to determine the relative value of firms.
  3. EV/Sale ratio is better than using Price/Sales ratio as EV/Sales takes into account even the outstanding debts of a company. Lower this ratio the better it is as the stock is thus considered undervalued. But, again we should consider other parameters too while investing into a stock.

summary

  • EV is the Takeover price of a company ie. the total cost of buying the company, including its debt and leftover cash.
  • Enterprise value is more comprehensive than market capitalisation as it takes debt into account. EV provides a clear picture of the company as debt is added to and cash reserve subtracted from market capitalisation.
  • While comparing the stocks of capital intensive industries, Enterprise Value of company plays a very crucial role.