In this lesson, we'll discuss enterprise value. This is a popular financial metric that tries to answer the question: how much would it cost me to buy the whole company? We'll also describe the various financial ratios that use enterprise value.
Imagine a fictional manufacturing company called Widget Inc. (WI). After WI's release of the past year's annual financials, newspapers might read, ''Widget Inc. (WI) continues to grow their enterprise value (EV).'' Another article may describe how ''WI is currently trading at an EV/EBITDA multiple of 20x.'' Let's learn what those sentences convey about the widget manufacturer.
Enterprise value is a measure of a company's total value. It captures the price someone would need to pay for the entire company - debt, cash and all. Yes, when one company buys another company, they assume that company's debt. This is a liability that will go on the acquirer's balance sheet. To help them finance the acquisition they use the cash held by the company that will be acquired. For example, if a company pays $10B for another company that has $2B of cash in the bank, the true purchase price (without debt consideration) is $8B. Once they pay the $10B they immediately get the $2B back as a 'refund' on their purchase price. Enterprise value tries to capture the value of the entire company, debt, cash and all. It is calculated as follows:
Market Value of Equity + Market Value of Preferred Shares + Market Value of Debt + Minority Interest - Cash = Enterprise Value
Let's unpack each part of the equation:
Market Value of Equity - This is also known as market capitalization. It measures the market's price for the book value of equity of the firm. This is the price an investor needs to pay to be the sole shareholder of the company. It is calculated by multiplying shares outstanding x per share market price. If the company had 1M shares outstanding and each share traded for $50, then the market value of equity for that company would be $50M.
Market Value of Preferred Shares - Preferred shares are a mix between equity/debt securities. They often pay fixed amounts of interest like debt, but they can have voting rights like equity. Like market value of equity, to calculate this part of the equation we multiply the number of preferred shares outstanding x per share market price.
Market Value of Debt - Debt includes short-term, current, and non-current bonds/notes outstanding (what the company owes to another party). We can calculate the market price of debt by looking in the public markets at what the debt is currently trading for.
Minority interest - This is when the company is partly owned by another entity. That other entity needs to own less than 50% of the voting shares to have a 'minority' interest. The entity and company report the value of that minority interest is during each accounting period.
Cash - This includes available cash, cash equivalents, and short-term investments.
Enterprise Value for Widget Inc.
Let's calculate Widget Inc.'s enterprise value for 1996 and 2016.
1996: Let's assume the market value of equity was $114B. There were no preferred shares outstanding. The company held $1.1B of outstanding debt, there was no minority interest held by a 3rd party. The company had retained $1.4B of cash. Total enterprise value was:
$114B + 0 + $1.1B + 0 - $1.4B = $113.7B
Notice, how close it is to equity value because the company did not hold very much debt at that time. And what debt it did hold could be quickly retired by the cash the company held.
2016: Let's assume, market value of equity has grown to $189B. There are no preferred shares. The company has significantly increased its debt to $42.2B. There is $158M of minority interest, and the company holds $18.2B of cash. Total enterprise value was:
$189B + 0 + $42.2B + $158M - $18.2B = $213B
This is the price an entity would need to pay for the whole company.
Analysts pair enterprise value with income statement and balance sheet items to understand the company's profitability and operations. We'll discuss two of the most popular financial ratios.
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Enterprise Value / Earnings Before Interest Taxes Depreciation & Amortization ((EV / EBITDA)
We have already addressed Enterprise Value. EBITDA is a rough estimate of the cash the company generates. An Enterprise Value of $100M and EBITDA of $10M gives a ratio of 10x. Put another way, it will take the company 10 years if it continues to generate cash at the same level until its total return equals the price it paid. Buying the whole company costs $100M. Each year the investor earns $10M. After 5 years, they have earned $50M in total. After 10 years, they have earned $100M, equal to their initial investment.
A high EV/EBITDA ratio means a company is more expensive because it will take many years before the investor has earned in total what he/she paid for the company. Conversely, a low EV/EBITDA ratio means a company is relatively cheap. We calculated the 2016 EV for Widget Inc's at $213B, and let's say their EBITDA was $10.65B. Their EV/EBITDA ratio was then $213B/$10.65B = 20x. It will take Widget Inc. investors 20 years to earn back their purchase price.
Enterprise Value / Sales (EV / Sales)
EV/Sales is another common ratio used by analysts. Like EV/EBITDA, the higher the ratio, the more expensive the company, all else being equal. The opposite is also true. The lower the ratio, the less expensive. In 2016, Widget Inc's enterprise value was $213B and let's say their sales were $50B. Their EV/Sales ratio would then be 4.26x.
In this lesson, you learned analysts calculate enterprise value to measure how much someone would need to pay for an entire company. The equation to calculate enterprise value is:
market value of equity + market value of preferred shares + market value of debt + minority interest - cash
Two financial ratios that analysts often talk about, the EV/EBITDA and EV/Sales, can show how many years it will take investors to earn back their purchase price.
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