Learn How to Calculate the Enterprise Value of a Company
The Role of Enterprise Value in the Takeover Price of a Business
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 it frequently, especially when discussions of mergers and acquisitions arise.
By writing this overview of the basic components and concepts of enterprise value, I hope to help you understand 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
The basic definition of enterprise value is simple enough and can be quickly memorized. To put it bluntly, enterprise value is a figure that theoretically represents the entire cost of a company if you, or some other investor, were to acquire it lock, stock, and barrel. For a publicly traded company, this would mean taking it private.
Enterprise value is a more accurate estimate of takeover cost than market capitalization because it takes includes a number of important factors such as preferred stock, debt (including bank loans and corporate bonds), as well as backing out cash reserves, which are excluded from the latter metric.
How Enterprise Value Is Calculated
Enterprise value is calculated 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 is what it would cost you to buy every single share of a company’s common stock, preferred stock, and outstanding debt. The reason the cash is subtracted is simple: once you have acquired complete ownership of the company, the cash becomes yours).
Let’s examine each of these components individually, as well as the reasons why they are included in the calculation of enterprise value.
The Components of Enterprise Value
- Market Capitalization: Sometimes referred to as "market cap", market capitalization is calculated by taking the number of shares of common stock multiplied by the current price-per-share. 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 issue that must be redeemed at a certain date at a certain price is, for all intents and purposes, debt. In other cases, preferred stock may have the right to receive a fixed dividend plus 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 existence 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 responsible for repaying the $5 million debt out of the cash flow of the business – cash flow that otherwise could have gone to other things.
- Cash and Cash Equivalents: Once you’ve purchased a business, you own the cash that is 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, it is subtracted from the other components when calculating enterprise value.
Why Enterprise Value Is Important
Some investors, particularly those who subscribe to a value investing philosophy, will look for companies that are generating a lot of cash flow in relation to 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 out of the business and spend it or put it into other investments.
Personally, my favorite way to measure such an enterprise is through a calculation known as owner earnings, then comparing it to the tangible invested capital.