What is Good Enterprise Value & How to Calculate: Formula & Meaning
What is Enterprise Value?
In financial terms, the Enterprise Value is the total value of a firm. It includes market capitalization and net debt (market value of debt - cash and equivalents). Enterprise Value (EV) can also be described as the theoretical value of purchasing a company. In simple terms, capturing the value of a company is known as Enterprise Value.
EV is the stock price multiplied by the total number of stocks and debts. However, cash and cash equivalents may be taken out of the equation. Cash equivalents are an enterprise's short-term investments that can be used for paying previous debts. Therefore, Enterprise Value can be expressed in the form of a formula, Enterprise Value Formula, as given below:
EV = Marketing Capitalization (number of outstanding shares × share price ) + Market Value of Debts - Cash & Equivalents
EV = MC + Total Debt - C
MC= Market Cap; equal to the current stock price multiplied by the number of outstanding stock shares
Total Debt= Equal to the sum of short-term and long-term debt
C= Cash and Cash Equivalents; Liquid assets of a company, but may not include marketable securities
With this formula, it can also be inferred that enterprise value is better and of more use in a business than market capitalization, as EV debts are also considered.
Applications of Enterprise Value
- For estimating the company's takeover price, as it considers the company's debts.
- EV/EBITDA is of more use than the PE ratio when two similar companies with different financial structures are compared.
- EV/Sales ratio proves to be better than the Price/Sales ratio to understand relative values as debts are considered in EV.
- Lower the EV/Sales ratio, the better it is, as the stock is considered undervalued.
- Many financial ratios that measure company performance are based on enterprise value.
Components Of Enterprise Value
The components that account for the EV are:
Market Capitalization (Market Cap):
The number of outstanding shares and preferred stock is referred to as market capitalization.
Debt is a necessary element of the formula. Total debt refers to the endowment from banks and other sources of credit. There are short-term and long-term debts in the market. The book value of debt can also be used if the market value of debt is unknown.
The debt gets adjusted by subtracting cash and equivalents from it because when a company has been acquired, the acquirer can use the company's money to pay off the assumed debt.
Cash & Equivalents:
Cash and cash equivalents are the most liquid assets in a company's statement. Short-term investments, commercial paper, marketable securities, money market funds, certificates of deposits, drafts, money orders, or treasury bills a company possesses can be considered some examples of Cash and Cash Equivalents. The cash and equivalents amount is subtracted from EV as it reduces the purchasing cost of the company we want to acquire. The claimant can use the cash immediately to pay off some part of the debt hence making it an essential component of the enterprise value.
Unfunded pension Liabilities:
A company must set aside several funds to make pension payments in an unfunded plan. This can be added to the market capitalization if this value is present.
For EV calculation, minority interest can be added to the market cap. Minority Interest is the equity value of a subsidiary with less than fifty percent share.
Enterprise value differs from simple market capitalization in various ways and is considered a more accurate representation of a company's value. It gives investors an understanding of the company's value.
What Is A Good Enterprise Value?
EV is a good indicator of a firm's total value, but EV/EBITDA is an even better indicator. The lower the ratio, the better the value. A below 10 EV/EBITDA is considered healthy. A negative EV/EBITDA ratio in a well-established firm's case means they have a lot of idle money. This is a sign that the company is not using its assets well. Idle money can be used for various things, such as distribution, research, buybacks, maintenance, employee pay raises, bonuses, paying off debts, expansion, or development. Thus, A Good Enterprise Value is the better way of calculating and demonstrating the company's total value. EV determines the company's total value, whereas EBITDA measures the company's overall financial performance.
This ratio is used in several situations. It may be more helpful than the P/E ratio when comparing companies with different financial structures. EBITDA is beneficial and essential in valuing capital-intensive businesses with high reduction rates. EBITDA can be both, negative and positive. Negative EBITDA shows the extra money in a firm; however, it is usually positive even when earnings per share are not the same.
One of the multiples used for data mining Al value of a firm is EV/sales. Lowering the EV by sales ratio more attractive or undervalued is the company. A negative EV/Sales ratio implies the firm can pay off all its debt. Compared to price by sales ratio, easy buy sales are regarded as a more accurate measure.
Enterprise Value estimates the total value of a firm. It is used as the basis for specific financial ratios, measuring the firm's performance. The EV relates the firm's total value to a measure of operating earnings generated. It is used by other companies when considering an acquisition or holding a share. EV/EBITDA and EV/Sales are appropriate ratios for measuring a company's market capitalization. It is an excellent use for investors to estimate the company's size and value and further evaluate their stock choices accordingly.