What It Measures
It measures what financial markets believe a company’s ongoing operations are worth.
Some people also define enterprise value as what it would actually cost to purchase an entire company at a given moment.
Why It Is Important
Enterprise value is not a theoretical valuation but a firm and finite value, logically determined. It tells an individual investor the underlying value of his stake in an enterprise. For potential acquirers considering a takeover of a company, enterprise value helps them to determine a reasonable price for their desired acquisition.
How It Works in Practice
Although it is a finite figure, enterprise value can be calculated in two ways. One method is quicker, but the other is more thorough and thus more reliable.
The quick way is simply to multiply the number of a company’s shares outstanding by the current price per share. Using this approach, the enterprise value of a company with 2 million shares outstanding, and a share price of $25, would be:
Enterprise value = 2,000,000 × 25 = $50,000,000
However, this value is based on the market’s perception of the value of its shares of stock; it also ignores some important factors about a company’s fiscal health. The second, more complete, method is therefore preferred by many experts. This method calculates enterprise value as the sum of market capitalization, plus debt and preferred stock, minus cash and cash equivalents:
Enterprise value = Market capitalization + Long-term debt + Preferred stock – Cash and equivalents
If market capitalization is $6.5 million, debt totals $1 million, the value of preferred stock is $1.5 million, and cash and equivalents total $2 million, enterprise value would be:
6.5 + 1 + 1.5 – 2 = $7 million
This more thorough calculation recognizes the existence of both a company’s debt and of the amount of cash and liquid assets on hand. No matter how a stock may fluctuate, these sums are relatively constant, and the amount of debt can be very significant. Debt—and cash, too—can be just as important during a company’s sale, since new owners both assume existing debt and receive any cash on hand. Indeed, more than a few acquisitions are financed in part with funds of the acquired company.
Tricks of the Trade
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Financial markets often use the market capitalization figure for enterprise value, but they really are not the same thing.
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Experts will occasionally refer to “total enterprise value,” but its definition and formula are virtually identical to this second formula enterprise value. Total enterprise value is only meaningful to those who use the quick method to compute enterprise value.
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A company’s value is sometimes expressed as “the total funds being used to finance it.” This is increasingly used in place of the price/earnings ratio, and indicates the economic rather than the accounting return that the company is generating on the total value of the capital supporting it. Companies that have borrowed heavily to finance growth, or that have paid large premiums for acquisitions or assets, are more frequently evaluated by this method.
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