Enterprise value is used extensively in finance, especially in a merger or acquisition. Enterprise value reflects the market value of an entire business, with both ownership interests and asset claims from debt and equity included. For that reason, it is the buzzword among M&A professionals as it shows the theoretical price of purchasing a business before a takeover premium is considered.
1. What is Enterprise Value?
Simply speaking, enterprise value is the effective cost of buying a company. For a publicly traded company, this cost includes the cost of buying up all of its shares, preferred stocks, and debt (bank loans and corporate bonds).
Enterprise value is considered to be a more accurate representation of a firm’s value than market capitalization or market equity value because it includes the value of a firm’s debt, which needs to be paid off by the buyer when they take over the company.
In addition, enterprise value is used extensively in valuation. Enterprise value is employed in the calculation of enterprise multiples, which put enterprise value in relation to a certain metric of a company, such as EBITDA or EBIT. The enterprise value (EV)/EBITDA or EV/EBIT are useful valuation tools to compare the value of a company, with debt included, to other comparable companies within the same industry.
Enterprise value = Equity value + Preferred Shares + Market Value of Debt + Minority Interest – Cash and cash equivalents
Let’s break the formula down by components
Equity value is the total value of the company available to equity investors after any debts have been paid off. Equity value is calculated by multiplying the company’s diluted shares outstanding by the market price per share.
Equity value = Share price x Number of diluted shares outstanding
Preferred stocks are so called because they give their owners a priority claim over whenever the company pays dividends or distributes assets to shareholders. Preferred stocks, however, do not bear any prioritized rights over corporate governance. Typically, preferred shareholders have no vote in company elections.
Preferred stocks are hybrid securities because they can be regarded as both equity and debt. In the enterprise value formula, they are treated more like debt securities, because they pay a fixed amount of dividends and have a higher priority in asset claims. For this reason, preferred stocks must be added to equity value in the formula.
Minority (Non-controlling) Interest
Non-controlling interest is an ownership position in a subsidiary company, which is owned by outside investors and not the parent company. Typically, a minority interest is less than 50% of the total number of shares outstanding.
The parent company reports the financial results of the subsidiary company in its consolidated balance sheet to present a claim on assets by minority shareholders or in its income statement as a percentage of profits belonging to minority shareholders.
By including the value of the minority interest in the calculation, enterprise value reflects the total value of all the parent company’s subsidiaries.
Market value of debt
Total debt is the contribution of banks and other creditors to finance the company with short-term and long-term interest-bearing liabilities. The amount of debt is adjusted by subtracting cash from it because the acquirer would usually use the 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.
Cash and cash equivalents
Cash and cash equivalents are the most liquid assets of a company. Assets that usually fall into this item are short-term investments, marketable securities, commercial paper, and money market funds.
The reason why cash and cash equivalents get subtracted from the calculation of enterprise value is that they reduce the cost of acquiring the target companies. They will be used towards paying off a portion of the debt, paying dividends, or buying back debts.
3. Enterprise Value and Equity Value
Both equity value and enterprise value are important concepts you will encounter in any finance interview. It is really important to understand the difference between equity and enterprise value.
When a company is bought, the purchase agreement in-the-money dilutive securities get cashed out or get converted into an equivalent number of the buyer’s securities. Either of those scenarios would cost the buyer something when it acquires the company in question. Equity value is like the sticker price saying how much it costs to buy the company. However, there are additional items that can push up or push down the effective price afterwards, so the actual cost of buying that company might be different from the sticker price. This actual price is the enterprise value.
Enterprise value = Equity value + Debt and debt equivalents + Preferred Stock + Non-controlling interest – Cash and cash equivalents
Equity value = Enterprise value – Debt and debt equivalents – Non-controlling interest – Preferred stock + Cash and cash equivalents
Market enterprise value = Market equity value (Market Capitalization) + Preferred Shares + Market Value of Debt + Minority Interest – Cash and cash equivalents
Intrinsic enterprise value = Intrinsic equity value + Preferred Shares + Market Value of Debt + Minority Interest – Cash and cash equivalents
Market value of equity is calculated by multiplying the market value of each of its shares by the total number of outstanding shares.
The intrinsic value of equity is different from the market value. It is a measure of what a stock is worth. This measure is arrived at by complex valuation techniques rather than using the currently trading market price of that asset.
Market enterprise value is often used to determine the market price of the entire business, while the intrinsic value is used to represent the true value of acquiring that business.
Conclusion: Enterprise value is a concept used extensively in finance and financial interviews. It is really important to understand the concept as well as understand each component that makes up enterprise value. We hope that article gives you a firm grasp of enterprise value and how it is used across different areas of finance.