Enterprise Value Explained

[midas]

FYI - an important investment concept nicely explained

Enterprise Value Explained
Thursday October 27, 9:11 am ET
By Motley Fool Staff


Enterprise value (EV) represents a company's economic value -- the minimum someone would have to pay to buy it outright. It's an important number to consider when you're valuing a stock.
You may remember that market capitalization (the current stock price multiplied by the number of shares outstanding) also serves as a company price tag. But market cap ignores debt, and with some companies, debt is substantial enough to change the picture significantly. Enterprise value, on the other hand, is a modification of market cap that incorporates debt.

To understand the concept of enterprise value better, imagine that you're looking at two companies that have equal market caps. One has no debt on its balance sheet, while the other one is rather debt-heavy. Whoever owns the latter company will be stuck making lots of interest payments over the years -- so you probably wouldn't pay the same price for each company.

By the same token, imagine that you have two companies with equal market caps of $50 billion and no debt. One has negligible cash and cash equivalents on hand, and the other has $5 billion in cash in its coffers. If you bought the first company for $50 billion, you'd have a company worth, presumably, $50 billion. But if you bought the second company for $50 billion, it would have cost you just $45 billion, since you instantly have $5 billion in cash. These are the kinds of things enterprise value takes into account.

To calculate enterprise value, start with a company's market cap, add debt (found on a company's balance sheet), and subtract cash and investments (also on the balance sheet). To get total debt, add together long- and short-term debt.


Market cap = current share price * total shares outstanding
Debt = long-term debt + short-term debt
Enterprise value = market capitalization - cash & equivalents + debt
Let's examine Disney (NYSE: DIS - News), using its quarterly earnings report for the quarter ended in March 2004. Its roughly 2 billion shares, at a recent stock price at the time of this writing of about $26, yield a market cap of around $53 billion. To that, we add its $13 billion in debt and subtract its $2 billion in cash and cash equivalents. The result is $64 billion, a significantly higher number than the market cap.

Debt can make a big difference. If you paid $53 billion for Disney, you would actually end up with a total bill of $64 billion, because the company comes with a lot of debt. The enterprise value reminds all investors, large and small, that debt is a cost to the business.
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[Sniper]

Enterprise Value as MT calculates it, ignores a very important component of corporate valuation... The present value of future earnings [img]/images/graemlins/smile.gif[/img]

[LearnedfromTV]

[ QUOTE ]
Enterprise Value as MT calculates it, ignores a very important component of corporate valuation... The present value of future earnings [img]/images/graemlins/smile.gif[/img]

[/ QUOTE ]

And in fact it is the present value of future earnings, plus assets, minus debt, that the market uses to "calculate" market cap through buy and sell decisions. Since we all know markets are efficient, this must be equivalent to enterprise value, which makes it quite odd that market cap is a variable in their calculation of enterprise value. The efficient market can read debt off a balance sheet and incorporate it in its perfect pricing. There is no arbitrage, otherwise finance textbooks would be wrong.

[buffett]

[ QUOTE ]
Enterprise Value as MT calculates it, ignores a very important component of corporate valuation... The present value of future earnings

[/ QUOTE ]

Don't believe it, noobs. As the article clearly states:

Enterprise value = market capitalization - cash & equivalents + debt

And market cap is nothing more than the stock price, which is nothing more than the averaged opinion of everyone of the "present value of future earnings" of whatever company we're talking about.
-web, CFA

edit: I see I was 1 minute too late to the market cap party. nh, Mr. TV.

This should be obvious. If you only looked at stock, you ignore the fact that in determining the capital structure of a company, the equity-debt ratio can be driven by various reasons at the discretion of management. Thus, you must include the value of debt when calculating the enterprise value (and of course, you need to net out cash and securities).

[Sniper]

ok, maybe I didn't read well enough this time, but Buff, are you saying that debt levels aren't already factored into value already?

[buffett]

[ QUOTE ]
are you saying that debt levels aren't already factored into value already?

[/ QUOTE ]

Good point. If Company A has operating income (EBIT) of $100M a year and has $4B of debt to service, and Company B also has EBIT of $100M and no debt, and both companies have exactly the same growth prospects, then in theory EV(A) = EV(B). But, as you imply, in practice the market would probably value A at slightly less than B, given the fact that A has more risk.

[midas]

FYI-

I think there are a couple of misconceptions regarding enterprise value in this thread. If the company is public you need the total market cap or total equity value to compute EV. Market cap takes into consideration debt and cash levels in determing equity value. In determining how much a public company is worth, EV is an important tool especially for small or micro cap stocks.

For a private company, EV = what a buyer is willing to pay for the company. If EV > Total Debt then the equity gets some value. If EV < Total Debt, the equity is toast and the debt is very concerned as well.

[BadBoyBenny]

I didn't know that markets had perfect pricing. Could you please explain this to me?

[buffett]

[ QUOTE ]
There is no arbitrage, otherwise finance textbooks would be wrong.

[/ QUOTE ]
Oh, my.
I can't tell if the above comment is supposed to be a generalization, something specific about EV & market cap, or a facetious remark. In case it's the first one, here's a classic story to debunk that bunk: Palm. (CTRL+F for "most" and then read the next few paragraphs.)
A guy who works for Jim Chanos drives around in some fancy sports car (I forget which) that he calls The Palm Mobile.
-web