Financial Course Blog

This is one of my articles in the line of financial ratios and this time I'll write about what's the Enterprise Value Financial Ratio. It's not about the Enterprise Starship from Star Trek hehe :p

Enterprise Value is a value that theoretically can tell you how much would and should someone pay for a company in order to buy it. It's what the name says. Enterprise Value is a quite accurate estimate of buying cost and is a better indicator of value than the other financial ratio called Market Capitalization because it takes into consideration more factors than the latter.

How is it calculated?
The calculation is very simple(first the theory :p)

Enterprise Value = Market Capitalization + Preferred stock + Outstanding Debt - Cash and Cash Equivalents

in other words, enterprise value is the amount of money you would pay to buy every single share of a company's common stock, preferred stock and outstanding debt. The reason the cash and cash equivalents is subtracted is after you buy the company you own the cash too. Sounds a little silly to buy cash with cash, but the cash that you pay goes to the owner/owners of the company, and the cash in the company is the cash needed for the company to run. You wouldn't want your newly bought company to have cash problems in the first day :p

What is the Market Capitalization(aka market cap, mkt cap or capitalized/capitalised value) ?
Market Capitalization is simply the result of the multiplication between the number of outstanding shares of common stock and the current price-per-share. Sounds complicated? Because of the terms used...

Try to follow this example: Company X has 1 million shares of stock outstanding and the current stock price is $130 per share, the company's market capitalization is then $130 million( 1 million shares x $130 per share = $130 million market cap).

What is the Preferred Stock ?
One definition is that Preferred Stock is the opposite of the common stock described above in the Market Capitalization calculus. Preferred stock is the participation of a larget investor in the company, investor which could require a fixed dividend or a share of the profits of the company.

What is Debt ?
If you acquire a business, you acquire it's debt also. If for example Company X has a market cap value of $130 million and a debt of $20 million, then you spend $150 million. $130 million needs to be paid now and you are now responsible to pay the $20 million in debt from the cash flow of the business or from other sources. That can affect the strategy of the company on short term or longer term. Preferably is for the debts to affect as little the company as possible and for as short of a term as possible.

What are Cash and Cash Equivalents ?
Once you acquired the business you own it's cash legally. After you own it, you can do whatever you want with it, take it and put it in your pocket, reinvest it in the company, pay the employees a bonus for buying the company, etcetera. Ofcourse the best thing to do is to use it to invest in the company further, but this varies from case to case. Basically it can also serve to reduce your acquisition price and because of that reason it is subtracted from the other components when calculating enterprise value.

What's the importance of Enterprise Value ?
There are investors who look at the enterprise value in relation to the cash flow to see if they're generating a lot of cash flow because that would mean there's little need if any to invest in the company, the company is moving alot of money from left to right on the products it sells and things run smoothly. These investors would then not be forced to reinvest the profits back into the company and they could use these profits to finance other investments.
Also a good application of Enterprise Value in relation with other ratios is to see if a company is overevaluated, evaluated properly or underevaluated.

External links:
Enterprise Value on Investopedia

Enterprise Value Gets Into Gear

Enterprise Value on Wikipedia(Very nice article but more technical)