What is enterprise value (EV)?
Enterprise value (EV) is an economic measure reflecting the market value of the whole business. It is also called ‘Entity Value’ or ‘Firm Value’. It is the sum of claims of all the security holders, i.e., debt holders, preference shareholders, minority shareholders, common equity shareholders and others. Enterprise value is one of the fundamental matrix used in business valuation, financial modelling, accounting, portfolio analysis, etc. Enterprise or Entity value is more comprehensive than market capitalization (market cap) which includes only equity.
Formula to Calculate Enterprise Value (EV)
Market capitalization + Total debt – Cash = Enterprise Value
where, market capitalization is equal to the market value of equity shares (otherwise called the common equity).
The expanded version of this formula is:
- All the components are taken at market value (not book values), reflecting an opportunistic nature of the Enterprise Value (EV) matrix. Some proponents argue that debt should be accounted for carrying value or book value. This argument holds good in a situation of bankruptcy where all claims that should be settled before the claims of equity shareholders should be based on book value or par value. EV for the purpose other than bankruptcy should be based on market value and not book value to get the maximum advantage or market price. Further, ‘debt’ is less liquid than ‘equity’ so that the ‘market price’ may be significantly different from the price at which an entire debt issue could be purchased in the market.
- Cash is subtracted because when it is paid out as dividend, it reduces the net cost to the potential purchaser. When the cash is used to pay the debts the same effect is accomplished.
- As the minority interest reflects the claim on consolidated assets of the enterprise, it is added.
- As the value of associate companies reflects the claim on assets consolidated into other enterprise, it is subtracted.
- EV should also include such special components as unfunded pension liabilities, employees stock option, environmental provisions, abandonment provisions, and so on, for they also reflect claims on the enterprise’s assets.
- Enterprise Value (EV) can be negative in certain cases. For example, when there is more cash in the enterprise than the value of the other components of EV.
- EV = NPV (Net Purchase Value) of the enterprise.
Enterprise value measures the value of a company as on a particular date. It is calculated by making adjustments to the market capitalization of a company. The formula for measuring enterprise value is described in the ensuing paragraph:
With the enterprise value as a measure, the companies can be compared easily irrespective of their capital structure. Moreover, enterprise value is used to calculate the ratio of EV to EBIDTA multiple. EBIDTA stands for Earnings before Interest, Depreciation, Tax and other Appropriations. Hence, it can be calculated by adding back the figures of interest, depreciation and other appropriations to the amount of Profit before Tax (PBT). It indicates that the value of the enterprise is equal to number of times of the company’s earnings. As the figures of interest, depreciation and tax are added back, it makes the comparison between two enterprises easier by eliminating all the accounting and tax differences.
The above measure for GRUH for a period of five years is as follows:
Benefits of Enterprise Value (EV)
The benefits of enterprise value are as follows:
- Entity value represents a better idea of how much a company is really worth because it considers other relevant values along with the value of outstanding equity.
- While taking over an enterprise the purchaser acquires the enterprise’s debts and also cash/bank balance.
- Acquisition of cash/bank balance as a part or the purchase reduces the cost of buying because it would be a gain to the purchaser.
- This measure is considered to be a more accurate representation of enterprise’s value and often viewed as a theoretical take over price.
- Estimating enterprise value with the weighted average cost of capital gives the most accurate figure. (WACC is the rate at which an enterprise must pay to finance its assets.)
Disadvantages of EV are as follows:
- The main disadvantage of that enterprise value is not as easy to calculate market capitalization. Market capitalization is a simple multiplication of the number of shares by the share’s unit value, whereas enterprise value takes other less tangible factors into account making the calculation more elusive.
- Use enterprise value with weighted Average Cost of Capital (WACC) for buying a company.
- Do not over complicate calculations if it is for simple comparisons. In that case use market capitalization.
- Do not add cash into the value of the enterprise, take it away.
Benefitable use of Enterprise Value (EV) to EBITDA
Enterprise value to EBITDA or EV/EBITDA is a measure of the cost of a stock which is more frequently used for comparisons across enterprises than the price to earnings ratio (P/E ratio). EV to EBITDA ratio is a measure of how expensive a stock is? It measures the price (in the form of EV) an investor pays for the benefit of the enterprise’s cash flow (in the form of EBITDA).
This ratio can vary due to differences in the calculation of depreciation and amortization which can be calculated at different rates over time. Unlike P/E ratios, EV to EBITDA ratios can be used to compare a wide variety of companies. EV to EBITDA is a better measure of an enterprise’s take over value as it can indicate how attractive a ‘ leveraged buy out’ candidate the enterprise would be.
- Market capitalization and entity value are not one and the same,
- EV is referred as a complex method.
- EV is defined as the total funds needed to finance the enterprise.
- If focuses less on returns, more on economic returns.
- Generally, EV is used to assess such enterprises that are relying on loans to finance their development, or that have paid high prices for assets or acquisitions.
As has already been explained, there are two methods of calculating ‘ Enterprise Value’. The more complex of the two is more reliable because it is more rigorous.
Let us understand the calculation of EV under both methods.
Company Zenith Ltd has 200,000 equity shares of $10 each, the market value of which is $25 per share. It has a long-term debt amounting to $1,000,000 and 50,000 preference shares of $10 each. The company’s cash and cash equivalents amounted to $300,000.
Calculate Enterprise Value (EV) (1) simple method, (2) complex method.
1. Simple method or Market Capitalization method
EV = Number of equity shares x current market price per share
= 200,000 x $25 = $5,000,000 EV
2. Complex method or Accurate method:
EV = Market capitalization + Long-term debt + Preference shares value – Cash and cash equivalents.
EV = $5,000,000 + $1,000,000 + $500,000 – 300,000
= 6,500,000 – 300,000
= $6,200,000 EV
Note: There is a significant difference between two valuations. That means the company is worth more than market capitalization.
The following information is extracted from the books of Fair Look Ltd for the year ending March 13, 2019. You are required to calculate (1) the Book Value of the assets and (2) the Enterprise Value of the company.
Balance Sheet as on March 31, 2020
- Dividend declared on equity shares 15%.
- Market value of equity shares is $40 per share.
- Market value of preference shares is $13 per share.
- Market value of 8% Debenture is on par with face value.
- Depreciation charged during the year amounted to $270,000.
- Corporate tax of the year amounted to $310,000.
- All accounts receivables are good and can be considered as equivalent to cash.
- Surplus transferred from profit and loss account during the year $140,000.
- (a) Book value of the assets = Total assets – Total liabilities
= $9,600,000 – $1,600,000 = $8,000,000.
Total liabilities = Debentures $800,000 + Bank o/d $500,000 + A/cs payable $300,000
(b) Tangible book value of assets = Total tangible assets – Total liabilities
= $7,000,000 – $1,600,000
(Intangible Assets = G.W $800,000 + B.V $1,000,000 + PR $500,000 + TM $300,000)
Tangible Assets = Total assets $9,600,000 – $2,600,000 Intangible assets = $7,000,000)
- Enterpirse value of the company:
(a) Market capitalization method:
EV = Number of equity shares x Current market price per share
= 500,000 share x $40 per share = $20,000,000.
Enterprise value = $20,000,000 (Market Capitalization).
(b) Compex Method or Account Method:
EV = Market capitalization + Long-term debt + Preference share value – Cash and Cash equipments
EV = $20,000,000 + $800,000 + $1,300,000 – ($600,000 + $500,000)
EV = $22,100,000 – $1,100,000 = $21,000,000
Therefore, Enterprise Value = $21,000,000
Note: There is a noticeable difference between the two valuations.
EV under complex/accurate method is $21,000,000
EV under the market capitalization method is $20,000,000
Difference resulting in increased valuation $1,000,000
That means, the company is worth more than market capitalization value. this would act as a negotiating price for the intending buyer.
EV = 21,000,000
EBITDA = 1,634,000
EV ÷ EBITDA = 12.85 times
Net Income = 890,000
EV ÷ Net Income = 29.60 times