One of the things that makes valuation somewhat tricky (and interesting!) as a subject is the ambiguity inherent in the process. There are many different ways to value a business, and each method paints a different picture of the whole. One of the ways to put a price on a business is by using something called "enterprise value." Let’s delve into what this metric is.
What is it?
Enterprise value is a valuation metric that focuses on how a company’s assets are financed. It is a more refined metric than market capitalization, and it actually includes market cap as part of its overall calculation. The basic formula for enterprise value is market capitalization plus net liabilities
Viewed another way, enterprise value is the sum of the debt and equity of a business. You will no doubt recall that this is equal to the total assets of the business. Now, while this may seem like a somewhat roundabout way of calculating the value of a business’s total assets, enterprise value is often a more convenient way to arrive at that final number. If someone asks you to value a set of items, it is easier to tell them how much money you spent buying them rather than listing each item separately, valuing it and then adding together the subtotals.
You may also have seen the formula for enterprise value written as "market cap + total liabilities - cash and cash equivalents." This is the same as the one given above, as net liabilities are calculated by subtracting cash from total liabilities.
So you can see why enterprise value is superior to market capitalization - it incorporates both a company’s debt and its cash position into the calculation. It can be thought of as the takeover price of the business.
What is it good for?
Enterprise value also forms the basis for a lot of financial analysis. For example, it appears as the numerator in the commonly used valuation ratio "EV/Ebitda," - or "enterprise value divided by earnings before interest, taxes, depreciation and amortization."
Essentially, EV/Ebitda is to the price-earnings (PE) ratio what EV is to market capitalization - it measures the same thing (how cheap or expensive a company’s shares are), but in a more refined and detailed way.
Although Ebitda is sometimes used in suspect ways by corporate management to overstate real earnings, it can be a useful measure of the inherent profitability of the business. Investors who rely solely on the price-earnings ratio risk underestimating how expensive a business with a lot of debt really is. Using EV solves that problem.
That said, as with all financial metrics and ratios, you should really use both the price-earnings ratio and EV/Ebitda together to get a more comprehensive picture of the business you are studying. It's always useful to have another tool in your arsenal.
Disclosure: The author owns no stocks mentioned.
Read more here:
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