Investing in the stock market may seem like a complex process, from the outside. You need to value companies based on several metrics such as revenue, profit margins, and cash flows, among others. It's also imperative to know specific terms and ratios that will help you evaluate publicly listed companies.
One of the most common terms used to analyze a company's financial health is enterprise value (EV). So, what is enterprise value, and how is it calculated? Let's find out with the help of an example.
EV measures the total value of a company and is considered a more inclusive alternative to market capitalization. The market cap is obtained by multiplying the company's stock price with its total number of outstanding shares. In addition to the market cap, the enterprise value also calculates a company's net cash balance minus its outstanding debt.
So, the formula to calculate the enterprise value is:
Enterprise value = Market Cap + Debt - Cash
Why is enterprise value used to evaluate a company?
Enterprise value is considered the theoretical buying price of a company in the case of an acquisition. It also provides investors with information about the liquidity of a business. So, if someone were to purchase a business outright, they would also have to service the latter's debt balance — a portion of which can be paid by the cash available on the balance sheet.
Why do you add debt and subtract cash while calculating the EV of a company?
A company's cash reserves lower its acquisition cost. So, if you acquire Company X for its market cap of $10 billion, you also have access to its cash balance of $1 billion, suggesting the effective acquisition cost is around $9 billion.
Alternatively, debt is an added cost as it's imperative to pay the company's shareholders and creditors to complete the acquisition.
If a company's cash balance is higher than its outstanding debt, the enterprise value will be lower than its market cap.
Like most other metrics, the enterprise value should not be viewed in isolation. For example, capital-intensive companies in the energy and utilities sector will have higher debt balances to support expansion plans. On the other hand, tech companies are asset-light and may have negligible debt on their books for the most part.
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