Enterprise value of a company: What exactly is it?
Company valuation is a basic indicator of a profitable business. Internally it helps management keep track of business growth. While externally, high valuations attract potential investors. Be it equity investment, merger, acquisition, or an IPO, the actual worth of a company is estimated using reliable valuation methods. This is usually done by professionals.
Enterprise Value of a Company
The simplest method to estimate the monetary value of a company is the equity route. Let’s say Company A has 2 million shares in the market. Each share is valued at $50. The total worth of the company thus stands at $100 million (2,000,000 shares * $50 per share). Investors get a quick estimate of a company using this approach. This is basically known as the market cap.
But to think of it, here investors only get an idea about how much of the company is owned by shareholders. Indeed a thriving business has many other aspects that contribute to its total worth. What about company debt? Are there any cash reserves? Are there other liabilities that an acquirer might inherit? The equity value alone does not clarify these factors. This is why valuation methods like Enterprise value are needed for a more holistic view.
What is Enterprise Value?
Enterprise value (EV) is the estimated value of a whole company. It can also be referred to as the Total enterprise value (TEV). It is the basis of any acquisition deal. It provides a wholesome view of the real value of a company. Unlike market cap, which solely focuses on one type of company ownership, enterprise value accounts for more. Apart from primary shareholdings, this includes all forms of assets, debts, and other liabilities as well. Thus, with a proper enterprise value during an M&A, both parties can claim to know the company’s total value.
Enterprise value calculator is a specific method used for company valuations in the case of mergers and acquisitions. Using this method, analysts arrive at an estimated value of a company to be acquired. But this value is only on paper. The actual value may vary based on other factors. We will discuss this in the later sections. But for now, it is important to know that enterprise value is used as a reliable alternative to company valuations based on market capitalization.
Why is Enterprise Value Important?
Mergers and acquisitions are profit-making ventures. A business house initiating an M&A is usually a large corporation. Apart from the value addition in terms of a new process, patent, or technology, the mother company has to churn profits from this venture. Thus it is standard practice to consider a few potential candidates before locking in the final one. They often choose from the best companies that are likely competitors in the industry and have a similar market cap. The enterprise value of a private company comes in handy to arrive at a final decision.
Let’s consider a simple example. ANC Corp is considering 3 options for an M&A deal. Their credentials are as follows:
| Company | Market Cap | Total Debt | Cash |
|---|---|---|---|
| A | $200M | $50M | $10M |
| B | $210M | $10M | $20 M |
| C | $220M | $80M | $75M |
The most straightforward Enterprise Value (EV) is calculated as:
Using this formula, here is the EV calculations for Company A, B, and C:
- EV of Company A = $200M + $50M – $10M = $240M
- EV of Company B = $210M + $70M – $20M = $260M
- EV of Company C = $220M + $80M – $75M = $225M
As we see, if ANC Corp considers only the market cap to measure company valuation, then of the three firms, the right choice would be Company A with the lowest market cap at $200M. However, if ANC Corp considers the bigger picture with an enterprise value that accounts for the total outstanding debt and cash reserves of the company as well, Company C with the highest market cap of $220M but the lowest EV at $225M is a clear winner.
Advantages and Disadvantages of using Enterprise Value
The enterprise value of a private company comes in handy while vetting businesses for takeover. However, finance experts agree that complete reliance on a single valuation method might be misleading. It is best to refer to a few to get the best and reliable estimate of a company’s market value. Some of the pros and cons of the EV method are:
Advantages:
On comparing enterprise value to equity value, EV is a far more reliable metric because:
- It helps determine the financial value of companies with a comparable market cap.
- It helps compare the valuation of companies with varying ownership stakes.
- It accounts for the debt component of the target company. This is important because the acquirer has to take responsibility for paying off debt.
- It accounts for the cash component of the target company. Higher the existing cash reserves, more benefits for the acquiring company. They can use the cash to pay off some portions of the debt or channel it into other projects.
- Since it accounts for all variables that make up a company’s economic structure, investors can rely on enterprise value to neutralize market risks.
- Owing to its holistic nature, EV is the basis of many valuation multiples and financial models such as REV, EBITDA, EBIT, FCFF, etc.
Disadvantages:
Relying solely on enterprise value can be problematic for certain industries that operate with high levels of debt. For example, the heavy machinery industry must use debt to purchase expensive equipment for business. These are operating assets. Unlike other industries where higher debt indicates volatility and risk, it is not a negative situation for the heavy machinery industry. It is a strategic business policy. Using enterprise value to determine company worth in these cases will lead to wrong conclusions.
How is Enterprise Value different from the Market Cap?
A company’s equity value, or market capitalization, is one component of its enterprise value. Both are used to make investment decisions, but they offer different perspectives. The market capitalization of a company is an estimate of the value of its outstanding common stock. On the other hand, enterprise value takes into account all of the company’s financial interests, including those of debt holders and subsidiaries. It calculates the value of the firm’s operating assets as a percentage of its revenue.
Investment bankers and analysts use enterprise value to estimate the market value of a company in mergers and acquisitions. Portfolio managers also use it in their stock selection process.
Portfolio managers use equity value/market cap for strategic investing. Each market-cap category provides a profile of the company’s stage, sector position, stability, business focus, growth potential, price volatility, and risk. There are styles within each category.
For example, growth companies are expected to outperform the market in terms of sales, revenue, and profit. Value companies are regarded as “bargains” because their share prices do not reflect their true worth.
How does Enterprise Value work in M&A deals?
Total Enterprise Value (TEV) is a company’s gross market value and is synonymous with the transaction value of an M&A transaction. In an M&A transaction, the valuation of a specific company is done using a variety of methods, including discounted cash flow and multiples. When calculating transaction multiples, several factors are taken into account, such as the type of premium a company must pay to obtain a controlling stake.
Multiples in the context of an M&A transaction are determined by prospective buyers’ valuations and their assessment of the target company’s potential cash flow. Prospective buyers’ valuations produce an implied multiple based on their proposed purchase prices and the company’s EBITDA. Different buyer groups have different motivations and expectations that drive their value perceptions.
Strategic buyers are typically concerned with returns in relation to their own internal cost of capital. Their analysis frequently includes synergies, cost savings, and market expansion opportunities. Financial buyers, such as private equity groups, evaluate an investment’s cash flow potential in order to achieve a targeted rate of return on equity given a capital structure that includes both debt and equity.
Enterprise Value Calculation
Enterprise value is best suited for industry-specific company valuations. It works best in a homogenous context to assess companies in a similar environment. In this section, we discuss how to calculate the enterprise value of a company.
Components of Enterprise Value
The EV of a firm can be derived using a simple formula. Before entering into the actual formulae and their variations, here is a brief about every component of the enterprise value calculator:
- Market Cap: Otherwise known as the equity value, the market cap is derived by multiplying the total number of shares with the price per share. This includes common shares, warrants, and convertible securities.
- Total Debt: This component of the enterprise value includes all the money borrowed from the market. That means bank loans and every long-term or short-term interest-bearing fund sourced from creditors. This component is important for EV calculation because the acquirer is responsible for closing the carried-over debt after an acquisition.
- Preferred stock: Market cap valuations account for all shareholdings that do not require a fixed dividend payback. However, there is a specific category of shares called preferred shares that demand regular dividends. These shareholders are on the priority list of paybacks in case of liquidity. They are an important component of any shareholding structure. Convertible notes, which are the basis of seed funds in a startup, eventually convert into preferred stocks. So this component cannot be denied in a company valuation metric, like enterprise value. They should be treated as a liability. Thus an acquirer has to account for preferred stock as part of a debt that they are responsible for paying off after a takeover.
- Minority interests: This is an exciting component every M&A analyst must account for. Imagine the target takeover company is a parent to many small subsidiaries. They may not be the largest shareholder (less than 50% stakes), but they are still the parent company. In these situations, though the parent company is a minority stakeholder, they are fully responsible for these subsidiaries’ economic situation (cash flow, revenues, and expenses). These factors add to the overall enterprise value.
- Cash: As discussed earlier, cash reserves or liquid assets are a positive add-on for any acquirer. They often use the carried over cash to pay off large portions of the carried over debt. This is one of the stark advantages of enterprise value to equity value. On the one hand, it accounts for the debt of the target company, but it neutralizes that by accounting for the cash reserves. Liquid assets include marketable securities and investments (mostly short-term).
How to calculate Enterprise Value
As discussed earlier, the simplest method to calculate enterprise value is to add the total debt of the target company to their market cap and deduct the total value of liquid assets. However, as we see in the previous section, some more components add value to company valuation when approached using the EV method. The extended formula then becomes:
Where:
- Total value of common shares: This is the market cap or equity value (Total number of diluted shares * price per share)
- Preferred shares: Considered as debt
- Total value of Debt: Long-term and short-term debts from government and private institutions
- Minority interest: Target Company’s minority stakes in various subsidiaries
- Cash & Cash equivalents: all liquid assets of the company
How does Enterprise Value work?
Enterprise value is an important company valuation metric. However, its wider role lies in its association with valuation multiples and various financial models. Valuation multiples help analyze one finance metric as a factor or another. It helps create a comparative value that becomes a common factor in the company valuation assessment of firms with similar capital structures. Valuation multiples are of two types – one is based on equity, and the other is based on enterprise value.
The most popular enterprise value-based multiple is the EV/EBITDA. This ratio takes the EV of a company and analyses it against the Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA). This is best used to evaluate capital-intensive companies. These firms have high levels of depreciation and amortization. Thus using EV to create this ratio offers a holistic view of the company’s market value.
Example of Enterprise Value
Now that we know the various components of an Enterprise Value Calculator, let’s discuss an example. Here are the details of XYZ Inc.
| Component | Value |
|---|---|
| Total no of diluted shares | 1,000,000 |
| Price per share | $20 |
| Market value of common shares (A) | $20,000,000 |
| Market value of preferred shares (B) | $5,000,000 |
| Long-term debt | $250,000 |
| Short-term debt | $50,000 |
| Market value of total debt (C) | $300,000 |
| Market value of Minority Interest (D) | $1,000,000 |
| Cash | $1,000,000 |
| Cash equivalents | $1,500,000 |
| Total cash (E) | $2,500,000 |
| Enterprise value | A +B +C +D – E |
| Enterprise value | $23,800,000 |
What is a good Enterprise Value?
Enterprise value as a stand-alone figure does not say much about the company’s merit in an industry. It only indicates the company’s value, not its current financial performance. Only when used as a factor of valuation multiples like EBITDA, EV helps choose the best financially profitable company for an acquisition.
An EV/EBITDA value of 11 to 14 is considered standard for M&A. This score is derived by observing trends among the top 500 publicly traded companies as per the S&P 500 Index. The exact average EV/EBITDA score was 14.20 as of Jan 2020.
How to find the Enterprise Value of a Private Company?
While you may now know how to find the value of a company using the EV formula, you may find that this is normally only used for publicly traded companies who have a market cap and relatively fixed capital structure. But what about small and medium sized private companies?
This is where EV multiples come into play. For companies with revenue or EBITDA, they can simply take these figures and times either EV/REV multiples or EV/EBITDA multiples based on the industry average to find their enterprise value. This approach is categorized under the Market Approach for private company valuations. For example if you know your sales in the next year are $1,000,000, and the EV/REV average in the industry is 2.5, then you can estimate the enterprise value of the company to be $2,500,000.
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Company valuation is an integral part of business operations. Startups need it to attract the best investors, while mature firms need to qualify for mergers and acquisitions or source business loans from banks and other creditors. At the same time, the company management needs it from time to time to analyze business growth. Thus it is best done with the help of professional valuation analysts to find your firm value.
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