Enterprise value is one of the more important concepts in investing for a variety of reasons. Once you’ve become accustomed to reading annual reports, business periodicals, and financial newspapers, you’ll no doubt come across the term frequently, especially in discussions of mergers and acquisitions.
Analyzing potential new investments and understanding the true impact of developments becomes easier when you understand certain financial concepts. The following explains the definition of enterprise value, why enterprise value matters, how enterprise value is calculated, and how to apply it to your investment methodology.
Enterprise Value Defined
At a high level, enterprise value can be defined as a number that theoretically represents the entire cost of a company if you, or some other investor, were to acquire 100% of it. For a publicly-traded company, this would mean buying up all of the stock shares, effectively taking the company private.
Enterprise value provides a more accurate estimate of takeover cost than market capitalization because it takes includes a number of other important factors, such as preferred stock, and debt (including bank loans and corporate bonds), and it backs out cash reserves, which don’t factor into the latter metric. A firm’s market capitalization consists only of the number of stock shares it has outstanding multiplied by its current share price.
You can calculate enterprise value by adding a corporation’s market capitalization, preferred stock, and outstanding debt together and then subtracting out the cash and cash equivalents found on the balance sheet.
In other words, enterprise value equates to the amount it would cost you to buy every single share of a company’s common stock, preferred stock, and outstanding debt. You would subtract the cash balance because once you have acquired complete ownership of the company, the cash becomes yours.
The Components of Enterprise Value
The following examines each of these components in some depth, as well as the reasons why they are included in the calculation of enterprise value.
Market Capitalization: Sometimes referred to as a market cap, you would calculate market capitalization by taking the number of shares of common stock multiplied by the current price per share of the company’s stock.
For example, if Billy Bob’s Tire Company had 1 million shares of stock outstanding and the current stock price was $50 per share, the company’s market capitalization would be $50 million (1 million shares x $50 per share = $50 million market cap).
Preferred Stock: Although it is technically equity, preferred stock can actually act as either equity or debt, depending upon the nature of the individual issue. A preferred stock issue that must be redeemed at a certain date at a certain price is, for all intents and purposes, debt. In other cases, preferred stockholders may have the right to receive a fixed dividend, plus they would also share in a portion of the profits (this type is known as “participating”).
Preferred stock that can be exchanged for the common stock is known as convertible preferred stock. Regardless, the preferred stock represents a claim on the business that must be factored into enterprise value.
Debt: Once you’ve acquired a business, you’ve also acquired its debt. If you purchased all of the outstanding shares of a chain of ice cream stores for $10 million (the market capitalization), yet the business had $5 million in debt, you would actually have expended $15 million because $10 million may have come out of your pocket today, but you are now also responsible for repaying the $5 million debt out of the cash flow of your new business—cash flow that you could have otherwise invested in growing the business.
Cash and Cash Equivalents: Once you’ve purchased a business, you own whatever cash it has sitting in the bank. After acquiring complete ownership, you can take this cash and put it in your pocket absent some sort of covenant restriction on any financing you used, replacing some of the money you expended to buy the business.
In effect, it serves to reduce your acquisition price. For that reason, you would subtract it from the other components when calculating enterprise value.
A Quick Interpretation
Some investors, particularly those who subscribe to a value investing philosophy, will look for companies that generate a lot of cash flow in relation to their enterprise value. Businesses that tend to fall into this category are more likely to require little additional reinvestment. This allows the owners to take the profit of the business and reinvest it in the company or put it into other investments.