The enterprise value is an economic measure that reflects a company's total value. The figure considers the entire market value instead of just the equity value. The enterprise value is used to value a target company for a potential takeover. How is the enterprise value calculated and why does it matter?
The enterprise value provides a more reliable estimate of the acquisition cost compared to the market cap. The enterprise value includes various other important factors like debt, preferred stock, and it excludes cash reserves. A company’s market cap only includes the number of outstanding shares it has multiplied by its stock price.
How to the calculate enterprise value
The enterprise value is a number that represents the entire cost of a company. A company’s capital structure doesn't impact its enterprise value. The financial metric is used in financial modeling, business valuation, accounting, risk analysis, and portfolio analysis.
The simple formula to calculate a company's enterprise value is:
- Enterprise Value = Market Capitalization + Total Debt - Cash and Cash Equivalents
The extended formula is:
- Enterprise Value = Market Capitalization + Preferred Stock + Total Debt + Minority Interest - Cash and Cash Equivalents
Components of the enterprise value
The main components of the enterprise value are:
- Market capitalization: You can multiply the number of outstanding common shares by its current price per share to calculate a company's market cap. For example, if Company A had 10 million shares of common stock outstanding and the current price per share was $50, the company’s market cap would be $500 million.
- Preferred stock: They are hybrid securities that have features of both debt and equity. Preferred stocks are treated more as debt when calculating the enterprise value because they pay a pre-determined amount of dividends. Preferred stocks are given higher priority over common stockholders to claim the company’s assets upon bankruptcy. The market value of the preferred stock is calculated by multiplying the par value of the stock by the number of outstanding preferred shares, which are both available on the company’s balance sheet.
- Debt: The market value of debt is calculated by adding both long-term and short-term debts on the company’s balance sheet. Once an investor acquires a company, the individual also acquires its debt.
- Minority interest: Minority interest is the portion of a subsidiary company nto owned by the parent company. Usually, the non-controlling interest is added in the enterprise value calculation because the financial statements of such a subsidiary are combined with the financial statements of the parent company. The minority interest is captured, as posted in the balance sheet.
- Cash and cash equivalents: Cash and cash equivalents like the cash balance, short-term investments, marketable securities, and commercial paper, are subtracted from the enterprise value calculation since they tend to reduce the acquiring cost of a business.
Significance of enterprise value
The significance of enterprise value revolves around the fact that it's used to assess what a business is worth. In other words, the enterprise value is a theoretical takeover price of a company that will be acquired. The enterprise value considers the impact of the cash balance and the outstanding debt. Also, the enterprise value helps to compare businesses with different capital structures.