What Is Enterprise Value (EV)?
Enterprise value (EV) is an economic measure reflecting the market value of the whole business. It is also called entity value or firm value.
EV is the sum of claims of all the security holders (i.e., debt holders, preference shareholders, minority shareholders, common equity shareholders, and others).
EV is a fundamental metric in business valuation, financial modeling, accounting, portfolio analysis, and other important tasks. EV is more comprehensive than market capitalization (market cap), which includes only equity.
Formula For Enterprise Value (EV)
The formula below is used to calculate EV:
EV = Market capitalization + Total debt – Cash
In this formula, market capitalization is equal to the market value of equity shares (otherwise called the common equity).
The expanded version of this formula is:
Explanation: EV Formula
All the components in this formula are taken at market value (not book values), reflecting the opportunistic nature of the EV matrix.
Some proponents argue that debt should be accounted for based on carrying value or book value.
This argument holds good in times of bankruptcy where all claims that should be settled before the claims of equity shareholders should be based on book value or par value.
EV for purposes other than bankruptcy should be based on the market value and not the book value. This ensures the maximum advantage or market price.
Furthermore, debt is less liquid compared to equity. Therefore, the market price may be significantly different from the price at which an entire debt issue could be purchased in the market.
The other key components in the EV formula above are mentioned as follows:
- Cash is subtracted because when it is paid out as a dividend, it reduces the net cost to the potential purchaser. When the cash is used to pay the debts, the same effect is accomplished.
- As the minority interest reflects the claim on consolidated assets of the enterprise, it is added.
- As the value of associate companies reflects the claim on assets consolidated into other enterprises, it is subtracted.
- EV should also include special components such as unfunded pension liabilities, employee stock options, environmental provisions, abandonment provisions, and so on. This is because they also reflect claims on the enterprise’s assets.
Noteworthily, EV may be negative in certain cases. For example, when there is more cash in the enterprise than the value of the other components of EV, the value will be negative.
Another way to conceptualize EV is as follows:
EV = Net purchase value (NPV) of the enterprise
As shown so far in this explanation, EV measures the value of a company on a particular date. It is calculated by making adjustments to the market capitalization of a company.
Using EV as a measure, companies can be compared easily irrespective of their capital structure. Moreover, EV is used to calculate the ratio of EV to EBIDTA multiple.
EBIDTA stands for earnings before interest, depreciation, tax, and other appropriations.
Hence, EBIDTA can be calculated by adding the figures of interest, depreciation, and other appropriations to the amount of Profit before Tax (PBT). It indicates that the value of the enterprise is equal to a multiple of the company’s earnings.
As the figures of interest, depreciation, and tax are added back, it makes the comparison between two enterprises easier by eliminating accounting and tax differences.
The above measure for GRUH for a period of five years is shown in the table below.
Benefits of Enterprise Value (EV)
The benefits of enterprise value (EV) are as follows:
- EV gives a better impression of a company’s real worth because it considers other relevant values, along with the value of outstanding equity.
- When taking over an enterprise, the purchaser acquires the enterprise’s debts and also cash/bank balance.
- Acquisition of cash/bank balance as a part of the purchase reduces the cost of buying because it would be a gain to the purchaser.
- This measure is regarded as a more accurate representation of EV and is often viewed as a theoretical take-over price.
- Estimating EV with the weighted average cost of capital (WACC) gives the most accurate figure. WACC is the rate an enterprise must pay to finance its assets.
Disadvantages of EV
The main disadvantage of EV is that it is more complex to calculate than market capitalization.
Market capitalization is a simple multiplication of the number of shares by the share’s unit value. By contrast, EV takes other less tangible factors into account, making the calculation more elusive.
Points of Caution
- Use EV with the weighted average cost of capital (WACC) to evaluate a company before purchasing it
- Do not overcomplicate calculations if they are for simple comparisons. In such cases, simply use market capitalization
- Do not add cash into EV; instead, take it away
Benefits of Enterprise Value (EV) to EBITDA Ratio
Enterprise value to EBITDA or EV/EBITDA is a measure of the cost of a stock. It is used more frequently than the price to earnings ratio (P/E) for comparisons across enterprises.
EV/EBITDA measures how expensive a stock is. It measures the price (in the form of EV) an investor pays for the benefit of the enterprise’s cash flow (in the form of EBITDA).
This ratio may vary due to differences in the way depreciation and amortization are calculated (e.g., at different rates over time).
Unlike P/E ratios, EV/EBITDA can be used to compare a wide variety of companies. EV/EBITDA is also a better measure of an enterprise’s take-over value as it can indicate how attractive the enterprise would be as a leveraged buyout candidate.
- Market capitalization and enterprise value (EV) are not the same
- EV is a complex method
- EV is defined as the total funds needed to finance the enterprise
- EV focuses less on returns and more on economic returns
- Generally, EV is used to assess enterprises that rely on loans to finance their development or that have paid high prices for assets or acquisitions
Ways to Calculate Enterprise Value (EV)
There are two ways to calculate EV: the market capitalization method (or simple method) and the complex method. The more complex method of the two has greater reliability because it is more rigorous.
In the following example, let’s consider how to apply both methods.
Zenith Ltd has 200,000 equity shares valued at $10 each. The market value of the shares is $25 per share.
The company also has long-term debt amounting to $1,000,000 and 50,000 preference shares at $10 each. The company’s cash and cash equivalents amount to $300,000.
Now, let’s calculate EV using the simple method and the complex method.
1. Simple method (or market capitalization method)
EV = Number of equity shares x current market price per share
= 200,000 x $25 = $5,000,000 EV
2. Complex method
EV = Market capitalization + Long-term debt + Preference shares value – Cash and cash equivalents.
EV = $5,000,000 + $1,000,000 + $500,000 – 300,000
= 6,500,000 – 300,000
= $6,200,000 EV
Note: There is a significant difference between these two valuations. The more complex calculation indicates that the company is worth more than its market capitalization.
The following information was extracted from the books of Fair Look Limited for the year ending 13 March 2019. You are required to calculate:
- Book value of the assets
- Company’s enterprise value
Balance Sheet as on 31 March 2020
- Dividend declared on equity shares 15%
- Market value of equity shares is $40 per share
- Market value of preference shares is $13 per share
- Market value of 8% debentures is on par with face value
- Depreciation charged during the year amounted to $270,000
- Corporate tax for the year amounted to $310,000
- All accounts receivables are good and can be considered as equivalent to cash
- Surplus transferred from profit and loss account during the year of $140,000
The book value of the company’s assets is calculated as follows:
Book value of assets = Total assets – Total liabilities
= $9,600,000 – $1,600,000 = $8,000,000.
Total liabilities = Debentures $800,000 + Bank o/d $500,000 + A/cs payable $300,000
(b) Tangible book value of assets = Total tangible assets – Total liabilities
= $7,000,000 – $1,600,000
(Intangible assets = G.W $800,000 + B.V $1,000,000 + PR $500,000 + TM $300,000)
Tangible assets = Total assets $9,600,000 – $2,600,000 Intangible assets = $7,000,000)
1. Market capitalization method
EV = Number of equity shares x Current market price per share
= 500,000 share x $40 per share = $20,000,000.
EV = $20,000,000 (Market capitalization).
2. Compex method (or account method)
EV = Market capitalization + Long-term debt + Preference share value – Cash and Cash equivalents
EV = $20,000,000 + $800,000 + $1,300,000 – ($600,000 + $500,000)
EV = $22,100,000 – $1,100,000 = $21,000,000
Therefore, EV = $21,000,000.
Note: There is a noticeable difference between the two valuations.
- EV under complex/accurate method is $21,000,000
- EV under the market capitalization method is $20,000,000
- Difference resulting in increased valuation $1,000,000
This means that the company is worth more than its market capitalization value. This would act as a negotiating price for the intending buyer.
EV = 21,000,000
EBITDA = 1,634,000
EV ÷ EBITDA = 12.85 times
Net Income = 890,000
EV ÷ Net Income = 29.60 times