I. Introduction
The enterprise value formula is used as the base of various financial ratios. It helps to evaluate a company’s total value. Besides, it is often used as a more reliable and comprehensive alternative to market capitalization. So, whether you are a finance enthusiast, business professional, or an investor, you must learn the EV formula and how to calculate it.
A. A brief overview of Enterprise Value (EV)
Enterprise value, or EV, is a crucial part of investing. While investing, you need to learn about the true value of the company, and EV can help with that. It is also essential for the business itself. EV is basically a calculation that reveals a company’s true value using market capitalization, debt, and any cash flow present in the company’s balance sheet.
B. The importance of understanding EV in finance
EV plays a crucial role in financial matters. It is the true value of a company or organization. It is mostly used by acquisition analysts and mergers. But EV gives investors too genuine insights into a company’s financial structure and helps them understand whether to invest in it.
II. What is enterprise value?
EV represents the true value of a company. It is an important part of a company’s financial structure and includes the total market capitalization and net debt of the company.
A. Definition and explanation in simple terms
By definition, EV is the measurement of a company’s total value or original value. This calculation includes the total market value of the company instead of focusing on the equity value. As a result, it includes both debt and equity. It can also be described as the theoretical value of purchasing a company.
B. Why EV goes beyond market capitalization
Market capitalization only observes the outstanding shares of a company, which can be often misleading, especially when the company has a larger cash reserve or significant debt. However, EV takes market capitalization and net debt into account, so it gives a much clearer idea of the company’s financial state. EV can go higher than the market cap if the company has low cash reserves and higher debt.
III. The components of enterprise value
The formula of enterprise value consists of several components that help to evaluate a company’s total value. These components include:
A. Market capitalization
Market capitalization is a primary component in a company’s EV calculation. It represents the net value of outstanding shares. Market cap equals the current stock price multiplied by the number of outstanding stocks.
Read More: How does market cap affect crypto prices?
B. Debt
Debt or net debt represents the sum of the company’s both short-term and long-term debts. It will include all kinds of debt the company owes.
C. Minority interest
Minority Interest, or MI, means the ownership or interest of less than 50% in a company. It represents the stock ownership and shareholding interest in a company. EV also includes a minority interest in company value calculation.
D. Preferred share
Preferred shares also fall under the list of key components of enterprise value. Preferred share is a class of share ownership that has higher earnings and claims on assets than the common or ordinary shares.
IV. The formula: How to calculate enterprise value
The formula for enterprise value is quite easy.
EV=MC+Total Debt−C
Where,
EV is the Enterprise Value
MC is Market Capitalization
Total Debt is the sum of long-term and short-term debt
C is Cash and Cash Equivalents
Step-by-step guide
The calculation of a company’s EV can be done via the following steps:
• First, find the current price per share from the stock market and collect the number of paid-up shares from the company’s balance sheet. Now derive the market cap using this formula:
Market Capitalization = Current Price Per Share x Outstanding Number of Paid-up Equity Shares.
• Calculate the current value of preferred stocks with the following formula:
Preferred Stock = Par Value x Outstanding Number of Preference Shares.
• Next calculate the current outstanding debt balance using:
Outstanding Debt = Bank Loans + Corporate Bonds.
• Now collect minority interest captured in the company balance sheet.
• Calculate current Cash and Cash Equivalents by using this formula:
Cash and Cash Equivalents = Cash Balance + Fixed Deposits and Current Account Deposits with Banks.
• Finally, calculate the enterprise value with this formula:
Enterprise Value = Market Capitalization + Preferred Stock + Outstanding Debt + Minority Interest – Cash and Cash Equivalents.
V. Why enterprise value matters
Enterprise value plays a fundamental role in analyzing the true value of a company. It can be represented as an estimated cost of buying a company with its actual market value and existing debts. Here we will learn in more detail why EV matters so much.
A. Insights into a company’s true value
The first thing that makes EV calculation a much-needed financial metric is that it gives insights into a company’s true value. As we have already mentioned, the formula of enterprise value looks at the total value of a company, including market cap, net debt, and cash/cash equivalents. So, it gives true insights into the company’s financial status.
B. How it aids in investment decisions
Another reason why EV calculation is so important is this: it gives investors a clear idea about a company’s financial state so they can decide whether they should invest in the company or not. A higher EV suggests that the company has significant debt and less cash; on the other hand, a low EV suggests a larger cash reserve and low debt.
VI. Common mistakes to avoid
Like any other financial metrics, the enterprise value calculation is also prone to several mistakes. Below we will discuss common mistakes you could make while calculating EV.
A. Pitfalls in EV calculation
Several pitfalls or limitations of EV calculation affect the results. The pitfalls of EV calculation include:
• Dependency on market data: It is highly dependent on the latest market data, which is prone to frequent fluctuations.
• Industry variable: High and low EV varies from one industry to another. So, it is unprofitable to calculate EV across industries.
• Excludes non-operating assets: Enterprise value doesn’t count non-operating assets, which is a major limitation in company value calculation.
• Complexity: EV calculation can be complex as it requires market cap, net debt, cash and cash equivalents, and minority interest which makes the EV calculation time-consuming.
B. Misinterpretations and their consequences
Although EV is a powerful financial metric, it is prone to several misinterpretations. Some of these are visualized below:
• Ignoring industry dynamics: Analysts can sometimes forget that EV varies from one industry to another. Ignoring these industry dynamics can lead to misconceptions about the company’s financial stability and structure.
• Overlooking company-specific factors: EV can provide a comprehensive value to the company. However, it cannot include companies’ unique features and potential. So, judging a company by only its EV rate can cause complications.
• Neglecting potential future growth: Enterprise value only calculates the present financial components, such as market cap, net debt, cash and cash equivalents present, etc. So, using EV only to determine a company’s worth can cause serious misconceptions.
VII. Real-world applications
The enterprise value calculation formula is widely used by both businesses and investors to assess the real-world value of a company. Here, we will discuss the real-world applications of EV.
A. Case studies illustrating the relevance of EV
Let’s look at the real-world case study of Apple Inc. as of 29, 2018, to illustrate the relevance of EV.
Market capitalization (millions) = 4,754.99 * $225.74 = $1,073,391
Outstanding debt (millions) = $11,964 + $102,519 = $114,483
Preferred stock = $0
Cash and cash equivalents (millions) = $25,913
Minority interest = $0
Based on the enterprise value formula Apple’s EV calculation is:
Enterprise value Apple Inc. (millions) = $1,073,391 + $0 + $114,483 + $0 – $25,913
So, Enterprise value Apple Inc. (millions) = $1,161,961.
As we have seen above, in addition to market cap, EV provides a more complete opinion of a company’s value by taking debt and cash into account. It is crucial to understand the true financial health and acquired costs. So, when Apple Inc. reveals its overall value, including financial obligations, it becomes a significant tool for all financial analysts and investors.
B. How investors use enterprise value Vs in decision-making
On the other hand, investors use EV calculation to assess the attractiveness or worthiness of a company to determine their investment decisions. They can utilize enterprise value to identify potential bargain points for the overrated stocks. They also use EVs for valuation models such as DCF or discounted cash flow analysis.
VIII. Conclusion
Enterprise value is a powerful financial metric that evaluates the total value of a company, including its market capitalization, net debt, and cash and cash equivalents. It is widely used by both businesses and investors.
EV calculation plays a pivotal role in investors’ decision-making. It also helps businesses assess the true value, which they need to establish in the company balance sheet. Businesses use EV calculation to assess and improve their true value in the current market. Investors, on the other hand, use EVs to identify companies that are worthy of investment.
So, whether you are a business professional, investor, or a finance enthusiast learning about EV calculation and how it works is essential. This will give you clear insights about a company’s true value and make your analysis more appropriate.
1. What do you mean by enterprise value?
Enterprise value refers to the total value of a company. It is calculated by taking into account market capitalization, short and long-term debts, and cash or cash equivalents from the balance sheet. It is often used as an alternative to the market cap of a company.
2. What is the formula for EV?
Below is the formula for the calculation of the EV of a company:
Market Capitalization + Total Debt – Cash or Cash Equivalents = EV
3. What enterprise value is good?
EV is an indicator to show the total value of a company or its financial health. An EV below 10 is considered healthy for a company’s financials.
How do you calculate total enterprise value?
Total EV can be calculated by adding a company’s market cap, total debt, and preferred stock. Then subtract Cash or Cash Equivalents from it.
