What Is Enterprise Value?
What is enterprise value? Why is it used by so many successful investors? And what are all the parts of the equation that make up this important metric? All the answers… coming up!
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The most straightforward way to value a company is by multiplying its share price by the total number of shares outstanding. This gives you (what is called) a company’s Market Capitalization, or Market Cap for short. Essentially, this tells you how much it would cost to buy every share of a company—to own 100% of that company.
This simple metric is what’s used when stocks are divided up by their size. For example, the Standard & Poor’s 500 (S&P 500) is supposed to represent 500 of the largest United States companies as measured by Market Cap.
Why EV > Market Cap
But for a successful investor—trying to fully understand the value of a company, not just what all the shares are worth, but the actual complete picture of a company’s value as an investment—this metric is not enough. (And I hope that statement makes more sense to you in just a second.) Because of this, more often than not those successful investors use Enterprise Value, or EV.
Enterprise Value more accurately represents the net impact—the bottom-line effect as an investment—on the portfolio of a potential acquirer who might take full ownership of a company.
So… if you’re buying shares in a company (you know, actually becoming part owner in that company), knowing what you would be out-of-pocket if you could just take over and purchase the whole entire thing (not a bad perspective—putting yourself in the shoes of a potential acquirer), that’s valuable information, right? It’s at least a more realistic representation than Market Cap of the value the market currently assigns to the company in question.
Five variables go into this calculation, and when you think about each one, it’s obvious why EV is more comprehensive and useful than the traditional Market Cap.
You start where we’ve already started, with the company’s Market Cap—what you would have to pay to buy 100% of the shares outstanding, becoming 100% owner the company.
You just bought the entire company, so that will increase your assets (right?)… but that’s not the end of it. That’s not the only effect this acquisition will have on your financial situation.
Plus total debt
If you’re now 100% owner of the company, you also now own 100% of its debts—both long- and short-term. So you need to factor that in. You can do that by adding it all to the Market Cap. Pretend as though, upon purchase, you’re also going to pay off every single creditor. (You don’t have to do that, but you will owe them all money at some point… so it needs to be factored in.)
Minus total cash
On the other hand, what if the company comes with some cash or cash equivalents? Well, that helps. That’ll work in your favor, so you can subtract that amount from the total amount you’re essentially paying for this company. Sometimes, this can be significant. Apple, for example, as of this recording, has well over $250B in cash reserves! Obviously, when you’re thinking about your Apple takeover bid (or just your own valuation of the company), this should factor in.
That’s most of your Enterprise Value calculation: Market Cap + Total Debt - Cash.
Plus other ownership interests
Now, I said there were five factors. There are. The other two are usually pretty small, if they even exist at all for your company in question.
At times, there are Minority Interests and/or Preferred Shareholders out there. These are other people or entities with claims to the company. Of course, then, they should be added in as well. They, too, are not considered in your basic Market Cap calculation, but obviously represent some value.
A Clearer Picture of the Actual Value
So there you have it: a simple way to gain a clearer picture of the actual value of a company. Market Cap + Minority Interest + Preferred Shares + Total Debt - Cash = Enterprise Value. And Enterprise Value comes up a lot in the ratios used to compare and assess the fair value of different companies.
We’ll be exploring some of those ratios, as well as other important metrics as we continue to build out your rapidly-growing, highly-diversified net worth, so stay tuned!