Ultimate Guide to Enterprise Value – Everything You Need To Know

Enterprise Value. Probably one of the most underrated yet powerful concepts in all of valuation. In this article/guide, we’ll take a deep dive into the Enterprise Value including what it means and how it works.

Let’s get into it.

What Is Enterprise Value

Enterprise value is nothing but the value of a company excluding cash and cash equivalents.

It differs ever so slightly from the generalised definition or equation for the value of a company.

But in essense, it’s nothing but the value of a firm.

The Enterprise Value is a critical component to any M&A (merger & acquisition) deal and is a key valuation metric used by investors and analysts alike.

Let’s now think about how to calculate the EV, and why it matters.

How to Calculate Enterprise Value

Enterprise value starts with the market capitalization of a company, then you add debt (yes, add debt), and finally subtract cash and cash equivalents.

Enterprise Value Formula

The Enterprise Value formula looks like this:

EV = Market Capitalization + Debt – Cash

Where:

• EV refers to the Enterprise Value
• Market Capitalization refers to the market value of the Equity of a company
• Debt reflects the market value of Debt of the company
• Cash represents “cash and cash equivalents”

Let’s now take a deeper look at the individual components of Enterprise Value.

Market Capitalization

This is a fairly well-known metric, though often misinterpreted as the “value of a company”.

For the record, the market capitalization is not the value of a company.

Unless the company has 0 debt, in which case one could argue it is the value of a company (but not the Enterprise Value!).

To calculate market capitalization, you would multiply the current stock price by the total number of outstanding shares.

Market capitalization is, as the name suggests, driven by the market, so it includes a measure of what the market thinks the company will be worth in the near future.

The market’s estimate of the value of the company (or even equity value) is broadly based on two factors:

• the present value of future expectations, and
• supply and demand

Debt

Debt in the context of Enterprise Value includes both short term and long term debt (i.e., it’s the Total Debt).

Importantly, the debt here is expressed in market value terms (not book value).

Thus, one couldn’t simply use the value for liabilities within the balance sheet, for example.

Examples of debt include everything from bonds, preferred stock (although this is sometimes treated as an Equity value), bank loans, debentures, etc.

Cash and Cash Equivalents

Cash and cash equivalents include the cash that you and I might think of when we think of “cash” (i.e., notes, coins, bank balances, etc).

This figure is reported in a company’s Balance Sheet.

The “cash equivalent” part sometimes confuses people but this simply refers to things like:

• certificates of deposit,
• bank deposit notes,
• money market instruments, and
• short-term treasury bills

These cash equivalents typically have nearly no interest-paying properties and are liquid enough to be considered cash, hence “cash equivalents“.

Crucially, this is NOT about Cash Flow. So it’s nothing to do with Free Cash Flow, Flow to Equity, etc.

It’s a static value of cash, not cash flow.

Understanding the Enterprise Value Formula

Okay, now that you know what the Enterprise Value is and how to calculate it, let’s consider 2 common questions that many people have.

Why Is Debt Added Rather Than Subtracted?

You might be wondering why debt was added to the Enterprise Value equation rather than subtracted.

This is ultimately because, when someone wants to buy a company, they must also put up the money required to absorb all of their debts as well, so this is added to the price tag.

The acquirer of a company buys the debt as well as equity of the company.

This is also consistent with the equation for the value of the firm:

   

Where:

• represents the value of the firm
• reflects the market value of debt, and
• denotes the market value of equity (aka Market Capitalization)

Debt is only subtracted when trying to calculate net assets (aka Equity).

For example, like this:

   

Why Is Cash Not Included in Enterprise Value?

Perhaps you’re now wondering, if an acquiring company buys the debt and equity of a firm, it must mean they buy all assets of the firm.

After all, according to the Accounting Equation and the Balance Sheet:

Assets – Liabilities = Equity

Therefore:

Assets = Liabilities + Equity

And since Cash and Cash Equivalents are an asset of the firm, surely the Enterprise Value should include it?

Somewhat paradoxically, the reason above is precisely why Enterprise Value excludes cash and cash equivalents.

Since the acquiring company gets ownership of all assets, they also get ownership of the asset of cash and cash equivalents, too.

This essentially reduces the cost of acquisition for the acquiring company.

Suppose ABC company is looking to buy XYZ Inc. for $1 billion. Further suppose that XYZ Inc. has $300m in cash and cash equivalents.

After ABC buys XYZ, they’ll have $300m in cash and cash equivalents. In a sense, their cost of acquisition is thus $700m instead of $1 billion.

Subtracting cash and cash equivalents allows an acquiring company to establish the value of the company net of cash and cash equivalents or cash reserves.

Put differently, you can think of Enterprise Value as the value of a company excluding its cash and cash equivalents!

Why Does Enterprise Value Matter?

The Enterprise Value is important for two primary functions of finance:

• to put a price tag on a company (i.e., for valuation), and
• as a performance metric to gauge a company’s performance

The latter function is in line with the idea that the value of a business/company is based on the present value of its future expectations.

The better a firm’s performance, the higher its EV (or even company value for that matter), ceteris paribus.

The news/media sometimes like to report on a company’s market capitalization as huge milestones for some companies like Apple crossing the “$2 trillion mark” for example.

These are often entertaining to see in that stock prices have no upper bound anyway! Thus, the hyper excitement of companies meeting some arbitrary mark is somewhat amusing.

That being said, it’s certainly no small feat to be the most valuable company on Earth.

Now, while the market cap is an important metric, the Enterprise Value is a more accurate metric for the value of a company.

Enterprise Value/EBITDA

Apart from its valuation accuracy, the EV is also used as a basis to report a number of ratios to compare with EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization).

And somewhat in line with that, it’s also used as one of many multiples for valuation, the most common one being the EV/EBITDA multiple.

Enterprise Value vs Market Cap

As highlighted earlier, it’s a common misconception to think of the market cap as the value of a company.

In reality, the Market Capitalization reflects the market value of Equity of a company.

There is however, one instance where the Market Capitalization is identical to the Enterprise Value.

This is only true if a company has 0 Debt and 0 Cash and Cash Equivalents.

Here’s why. We know that Enterprise Value is estimated as:

EV = Market Capitalization + Debt – Cash

If Debt = Cash = 0, then:

EV = Market Capitalization + 0 – 0

EV = Market Capitalization

In all other instances, however, Market Capitalization is NOT the same as Enterprise Value.

Enterprise Value vs Equity

Similar to the note above, but necessary to highlight because of jargon complications, Enterprise Value is NOT the same as Equity.

Remember that ‘Equity’ in and of itself can usually mean:

• Book Value of Equity (aka Net Assets, Shareholder’s Equity, Ownership Equity), or
• Market Value of Equity (the market capitalization)

The Book Value of Equity is largely irrelevant in the context of EV because we work with market values, not book values.

This brings us to the next comparison that people often make.

Enterprise Value vs Book Value

Generally speaking, Book Value refers to the Book Value of Equity.

As we highlighted above, this is largely irrelevant for the EV calculation.

The Book Value reflects the value of equity of a firm from an accounting standpoint.

Always remember that accounting values do not reflect the economic reality.

Final Thoughts: Enterprise Value

Enterprise value is simply a relatively accurate way of putting a price tag on a particular company.

It essentially represents the value of a company excluding its cash and cash equivalents, and is calculated as:

EV = Market Capitalization + Debt – Cash

While individual investors might think they don’t need to know EV, it can give anyone a good idea of what a company might cost to those who would want to buy it.

If another M&A season comes on us, and they happen all the time, it might help investors understand whether a company in their portfolio might be attractive for acquisition.

If you’re interested in learning more on how to value stocks, you’ll want to take a look at our stock valuation course.

And while you’re at it, you may also want to explore getting our Super Learner All Access Pass to get unlimited access to all our finance and investing courses.