Enterprise Value – EV Definition

Enterprise value (EV) is a measure of a company's total value, often used as a more comprehensive alternative to equity market capitalization. EV includes in its calculation the market capitalization of a company but also short-term and long-term debt as well as any cash on the company's balance sheet. Enterprise value is a popular metric used to value a company for a potential takeover.

$Enterprise value formula: EV = Market\, capitalization\, +\, Total\, debt - Cash\, and\, cash\, equivalents$Enterprisevalueformula:EV=Marketcapitalization+Totaldebt−Cashandcashequivalents

Where:

• Market capitalization is equal to the current stock price multiplied by the number of outstanding stock shares.
• Total debt is equal to the sum of short-term and long-term debt.
• Cash and cash equivalents are the liquid assets of a company, but may not include marketable securities.

1. Calculate the market capitalization if not readily available by multiplying the number of outstanding shares by the current stock price.
2. Total all debt on the company's balance sheet including both short-term and long-term debt.
3. Add the market capitalization to the total debt and subtract any cash and cash equivalents from the result.

Enterprise value (EV) could be thought of as the theoretical takeover price if a company were to be bought. EV differs significantly from simple market capitalization in several ways, and many consider it to be a more accurate representation of a firm's value. The value of a firm's debt, for example, would need to be paid off by the buyer when taking over a company. As a result, enterprise value provides a much more accurate takeover valuation because it includes debt in its value calculation.

Why doesn't market capitalization properly represent a firm's value? It leaves a lot of important factors out, such as a company's debt on the one hand and its cash reserves on the other. Enterprise value is basically a modification of market cap, as it incorporates debt and cash for determining a company's valuation.

Enterprise Value as an Enterprise Multiple

Enterprise value is used as the basis for many financial ratios that measure the performance of a company. An enterprise multiple that contains enterprise value relates the total value of a company as reflected in the market value of its capital from all sources to a measure of operating earnings generated, such as earnings before interest, taxes, depreciation, and amortization (EBITDA).

EBITDA is a measure of a company's overall financial performance and is used as an alternative to simple earnings or net income in some circumstances. EBITDA, however, can be misleading because it strips out the cost of capital investments like property, plant, and equipment:

• EBITDA = recurring earnings from continuing operations + interest + taxes + depreciation + amortization

The enterprise value/EBITDA metric is used as a valuation tool to compare the value of a company, debt included, to the company’s cash earnings less non-cash expenses. It's ideal for analysts and investors looking to compare companies within the same industry.

EV/EBITDA is useful in a number of situations:

• The ratio may be more useful than the P/E ratio when comparing firms with different degrees of financial leverage (DFL).
• EBITDA is useful for valuing capital-intensive businesses with high levels of depreciation and amortization.
• EBITDA is usually positive even when earnings per share (EPS) is not.

EV/EBITDA also has a number of drawbacks, however:

• If working capital is growing, EBITDA will overstate cash flows from operations (CFO or OCF). Further, this measure ignores how different revenue recognition policies can affect a company's OCF.
• Because free cash flow to the firm captures the number of capital expenditures (CapEx), it is more strongly linked with valuation theory than EBITDA. EBITDA will be a generally adequate measure if capital expenses equal depreciation expenses.

Another commonly used multiple for determining the relative value of firms is the enterprise value to sales ratio or EV/sales. EV/sales is regarded as a more accurate measure than the price/sales ratio since it takes into account the value and amount of debt a company must repay at some point.

Generally, the lower the EV/sales multiple, the more attractive or undervalued the company is believed to be valued. The EV/sales ratio can actually be negative at times when the cash held by a company is more than the market capitalization and debt value, implying that the company can essentially be by itself with its own cash.

• Enterprise value (EV) is a measure of a company's total value, often used as a more comprehensive alternative to equity market capitalization.
• EV includes in its calculation the market capitalization of a company but also short-term and long-term debt as well as any cash on the company's balance sheet.
• Enterprise value is used as the basis for many financial ratios that measure the performance of a company.

As stated earlier, the formula for EV is essentially the sum of the market value of equity (market capitalization) and the market value of debt of a company, less any cash. The market capitalization of a company is calculated by multiplying the share price by the number of shares outstanding. The net debt is the market value of debt minus cash. A company acquiring another company keeps the cash of the target firm, which is why cash needs to be deducted from the firm's price as represented by market cap.

Let's calculate the enterprise value for Macy's (M). For the fiscal year ended January 28, 2017, Macy's recorded the following:

We can calculate Macy's market cap from the information above. Macy's has 308.5 million outstanding shares valued at $20.22 per share:

• Macy's market capitalization is $6.238 billion (308.5 million x $20.22).
• Macy's has short-term debt of $309 million and long-term debt of $6.56 billion for a total debt of $6.87 billion.
• Macy's has $1.3 billion in cash and cash equivalents.

Macy's enterprise value is calculated as $6.238 billion (market cap) + $6.87 billion (debt) - $1.3 billion (cash).

• Macy's EV = $11.808 billion

Enterprise value is considered comprehensive when valuing a company because, if a company were to purchase Macy's outstanding shares for $6.24 billion, it would also have to settle Macy's outstanding debts.

In total, the acquiring company will spend $13.11 billion to purchase Macy's. However, since Macy's has $1.3 billion in cash, this amount can be added to repay the debt.

The price-to-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its current share price relative to its per-share earnings (EPS). The price-to-earnings ratio is also sometimes known as the price multiple or the earnings multiple. The P/E ratio doesn't consider the amount of debt that a company has on its balance sheet.

However, EV includes debt when valuing a company and is often used in tandem with the P/E ratio to achieve a comprehensive valuation.

As stated earlier, EV includes total debt, but it's important to consider how the debt is being utilized by the company's management. For example, capital intensive industries such as the oil and gas industry typically carry significant amounts of debt, which is used to foster growth. The debt could be used to purchase plant and equipment. As a result, the EV would be skewed for companies with a large amount of debt as compared to industries with little or no debt.

As with any financial metric, it's best to compare companies within the same industry to get a better sense of how the company is valued relative to its peers.