enterprise value

EV Gets Into Gear

The enterprise value - or EV for short - is an indicator of how the market attributes value to a firm as a whole. Enterprise value is a term coined by analysts to discuss the aggregate value of a company as an enterprise rather than just focus on its current market capitalization. It measures how much you need to fork out to buy an entire public company. When sizing up a company, investors get a clearer picture of real value with EV than with market capitalization.

Why doesn't market capitalization properly represent a firm's value? It leaves a lot of important factors out, such as a company's debt on the one hand and its cash reserves on the other. Enterprise value is basically a modification of market cap, as it incorporates debt and cash for determining a company's valuation.

The Calculation

Simply put, EV is the sum of a company's market cap and its net debt. To compute the EV, first calculate the company's market cap, add total debt (including long and short-term debt reported in the balance sheet), and subtract cash and investments (also reported in the balance sheet). Market capitalization is the share price multiplied by the number of outstanding shares. So, if a company has 10 shares and each share currently sells for $25, the market capitalization is $250. This number tells you what you would have to pay to buy every share of the company. Therefore, rather than telling you the company's value, market cap simply represents the company's price tag. The Role of Debt and Cash

Why are debt and cash considered in valuing a firm? If the firm is sold to a new owner, the buyer has to pay the equity value (in acquisitions price is typically set higher than the market price) and must also repay the firm's debts. Of course, the buyer gets to keep the cash available with the firm, which is why cash needs to be deducted from the firm's price as represented by market cap. Think of two companies that have equal market caps. One has no debt on its balance sheet while the other one is debt heavy. The debt-laden company will be making interest payments on debt over the years. (Preferred stock and convertibles that pay interest should also be considered debt for purposes of calculating value.) So, even though the two companies have equal market caps, the company with debt is worth more.

By the same token, imagine two companies with equal market caps of $250 and no debt. One has negligible cash and cash equivalents on hand, and the other has $250 in cash. If you bought the first company for $250, you will have a company worth, presumably, $250. But if you bought the second company for $500, it would have cost you just $250, since you instantly get $250 in cash. If a company with a market cap of $250 carries $150 as long-term debt, an acquirer would ultimately pay a lot more than $250 if he or she were to buy the company's entire stock. The buyer has to assume $150 in debt, which brings the total acquisition price to $400. Long-term debt serves effectively to increase the value of a company, making any assessments that take only the stock into account preliminary at best.

Cash and short-term investments, by contrast, have the opposite effect. They decrease the effective price an acquirer has to pay. Let's say a company with a market cap of $25 has $5 of cash in the bank. Although an acquirer would still need to fork out $25 to get the equity, it would immediately recoup $5 from the cash reserve, making the effective price only $20.

Ratio Matters

Frankly, knowing a company's EV alone is not all that useful. You can learn more about a company by comparing EV to a measure of the company's cash flow or EBIT. Comparative ratios

demonstrate nicely how EV works better than market cap for assessing companies with differing debt or cash levels or, in other words, differing capital structures.

It is important to use EBIT - earnings before interest and tax - in the comparative ratio because EV assumes that, upon the acquisition of a company, its acquirer immediately pays debt and consumes cash, not accounting for interest costs or interest income. Even better is free cash flow, which helps avoid other accounting distortions.

For a good example, go back to 2003 and look at the price of two comparable stocks: Sears and JC Penney. At $45 per share, Sears had a market cap of $13.5 billion and P/E (market cap/earnings) ratio of 10. But its balance sheet was burdened with nearly $30 billion in net debt. So Sears' EV was $43.5 billion, or about 14 its $3.4 billion in EBIT.

By contrast, JC Penney enjoyed a share price of $23 per share and a market cap of $6.1 billion and P/E ratio of 20, twice that of Sears. But because JC Penney owed a lot less - its net debt stood at $3.5 billion, its EV was $9.6 billion and its EV/EBIT ratio was only 10, compared to Sears'

EV/EBIT of 14.

By market cap (P/E) alone, Sears looked like it was half the price of JC Penney. But on the basis of EV, which takes into account important things like debt and cash levels, JC Penney was priced much less per share. As the market gradually discovered, JC Penney represented a better buy, offering more value for its price.

Conclusion

The value of EV lies in its ability to compare companies with different capital structures. By using enterprise value instead of market capitalization to look at the value of a company, investors get a more accurate sense of whether or not a company is truly undervalued.

Importance of Enterprise Value

Enterprise value is a measure of the actual economic value of a company at any given moment. Enterprise value measures what it would actually cost to purchase the entire company. Many investors use the current value of all of a company's outstanding shares as a proxy for its economic value. Known as market capitalization, the current market value of all of a company's shares is equal to the current number of outstanding shares multiplied by the current share price:

Market Capitalization = Number of Shares Out * Current Share Price

You can find the current share price almost anywhere, thanks to the wonder of 15-minute delayed and real-time quotes. Shares outstanding can be a little trickier, but truth be told I only use one source to find this number -- the latest quarterly earnings press release or SEC filing. Although the number appears in the quote feeds of a number of data providers, I have found that it often lags the latest reported quarter by a couple of weeks and seldom takes into account in timely fashion the shares issued to acquire another company.

Now, if market capitalization is the value of all of the outstanding shares, why use enterprise value at all? I mean, enterprise value only appears in a few business school textbooks that focus on cash-flow valuations. The rest of the investment media uses market capitalization. Well, let me let you in on a little secret. Wall Street is many things, but it is not thorough and it is not scientific. In fact, it is downright scary when you look hard enough and see that there is really no unified body of knowledge outside of the quite excellent Chartered Financial Analysts program (which has only about 40,000 graduates total ever) that analysts, market strategists, and pundits draw from. Carpentry (a quite noble profession) has a more rigorous set of intellectual standards.

Although market capitalization is the key component of the actual economic value of a company, it is hardly the only one. Using only market capitalization to value companies is kind of like using the down payment on a house as a proxy for how much a house is worth. The larger the mortgage on the house is, the more wrong you end up being. When a company carries long-term debt, which is essentially what a mortgage is, the company has pledged its own assets to borrow money. If someone were to acquire that company, she would also acquire responsibility for that debt. Much like the person who "assumes" a mortgage of $50,000 after paying $20,000 in equity for a home, a company that pays $20 million for the stock of a company with $50 million in debt has really paid $70 million for the entire company.

The simple fact is that debt matters. Now, many companies have an inconsequential amount of debt; however, there are plenty where the amount of debt that the company has is quite consequential. A controversial, Nobel prize winning economic theory called M&M (after two professors named Modigliani and Miller) proposed that the effective capital structure of a company was the market value of its equity plus its debt. The controversial part was when they went on to say that there is no optimum capital structure, meaning that every dollar of debt a company carried consumed a potential dollar of equity. Put another way, a company's value was a given. Whether it chose to recognize that value all in debt or equity was the company's choice -- there was no capital structure that resulted in a higher valuation without increasing earnings somehow.

Another very important factor to consider when analyzing a company is what it has in the bank. If a company has a hoard of cash or significant equity stakes in other publicly traded businesses, these are pretty easy to value and are obviously sources of liquidity for the company. Going back to our home example, say you bought a home for $70,000 -- $20,000 in cash and $50,000 in debt after assuming the mortgage. When you walked in the house, you found $20,000 in cash left by the previous owner. After putting this $20,000 in the bank, your effective purchase price becomes $50,000. Although you paid out $20,000 to the owner, you got it right back.

Because of the rather complicated rules of acquisition and corporate ownership, this somewhat ludicrous example happens all of the time in the business world. If a company has $20 million in cash in the bank, it is not like the outgoing Chairman can put it in his pocket as he leaves. That money belongs to the company -- and those who own the company. If someone is buying the company, that money really belongs to him or her. No one else can take it. As a result, when the old owners are paid off they are paid off with cash from the new owners -- leaving any cash in the company behind for the new owners to keep. Given that equity stakes in other publicly traded companies are really just as good as cash -- heck, maybe even better -- it makes sense to count this as part of the cash hoard for the purposes of determining what the actual economic price of a company is.

Given all of this, you can see that the real, economic purchase price of a company at any given moment is the value of the stock (the market capitalization), plus the debt that the company has taken on, minus any cash or investments it has on the books. This is what we call enterprise value. We use this instead of market capitalization because it is the actual economic purchase price of a company at any given moment. Enterprise value reflects the actual purchase price anyone acquiring a company would have to pay.

Enterprise Value = Market Capitalization + Long-term Debt - Cash & Investments

Why go to all of this trouble when some people argue that the value of the stock has already been

adjusted for the debt and cash a company has? Because no matter how much the actual price of the stock changes, the debt and the cash do not go away. An acquirer still has to take on the debt and still gets to put the cash in the bank whether the company's stock is worth $1 billion or one dollar. Debt and cash are economic realities and must be factored into the purchase price an acquirer pays for a company. Enterprise value is not a valuation, meaning the theoretical price at which a company should trade, but a value, meaning the current, real price as definite as if stuck on with a pricing gun.