Thursday, 21st October 2010

Enterprise Value

Written by George Traganidas Topics: Stock Investing, Wealth Building

When you are evaluating a company you need many tools that will help you to look at the company in different ways. One such tool is enterprise value. Here is a very good article from fool.com that explains what it is:

When trying to determine the value for a given company, a metric that many investors use religiously is market capitalization, better known by the shortened, slightly sassier term “market cap.” It’s simple enough to figure out — all you do is multiply the company’s shares outstanding by its current share price.

While market cap is an important number to have on hand, it’s definitely not the only information you need to assign a price tag to a company. To get a better picture of a company’s economic value, there’s another metric that more closely fits the bill: enterprise value (EV). This metric measures what it would actually cost to purchase the entire company outright. It’s a far more in-depth way to calculate a business’s true economic value. For example, enterprise value takes into account debt levels and cash reserves while market cap does not. With some companies, these elements can make a substantial difference in what a company is actually worth.

Let’s say you’re looking at two companies with the same market cap, but one of those companies has a substantial amount of debt. The debt-heavy company will have to fork over payments to cover that debt, possibly for many years. Investors shouldn’t pay the same price for a stake in that company as they would for shares of a debt-free business.

Two Companies
Here’s another example. Imagine two companies that have equal market caps of $5 billion and no debt. However, one has very little cash and cash equivalents on hand, while the other has $1 billion in cash. If you bought the first company for $5 billion, you’d have a company worth, presumably, $5 billion. But if you bought the second company for $5 billion, it would have cost you just $4 billion, because you instantly have $1 billion in cash. Enterprise value shows that key difference, market cap does not. Value investing gets even more interesting as you go down the market cap ladder, when cash reserves can account for a larger percentage of a company’s market cap. If the cash is there, that’s a floor. It’s money that can be paid out in the event of liquidation.

Enterprise value can highlight a real value opportunity when market cap would not. So now that you understand what EV is, here’s how to calculate it. Start with a company’s market cap, add debt, and subtract cash and investments (both are found on the company’s balance sheet). To get total debt, add together long- and short-term debt.

Market cap = current share price * total shares outstanding
Debt = long-term debt + short-term debt
Enterprise value = market capitalization – cash and equivalents + debt

Other Reasons to Trust EV
Why else does EV matter? For the same reasons that any of the shorthand metrics stock analysts use matter: comparison and analysis. Business is a dynamic enterprise, and different businesses can have very different capital structures, making comparisons odorous, as Shakespeare might note.

It can help you see beyond the market’s opinion and compare companies with different capital structures — making those comparisons smell, well, just a little bit nicer.

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