What is enterprise value?
Enterprise value (EV) shows a company’s total valuation. EV is used as a better alternative to market capitalisation because it is calculated by adding more vital components to the value of market capitalisation. The added components used in the EV calculation are debt, preferred interest, minority interest and total cash & cash equivalents. The values of the debt, minority interest and preferred interest are added with the calculated market capitalisation value, while the total cash & cash equivalents are subtracted from the calculated value to get the enterprise value.
Thus, a basic formula for calculating the EV is as follows:
EV = Market cap + market value of preference shares + debt + minority interest – cash & cash equivalents.
Theoretically, the calculated enterprise value can be considered as the price or value at which the company is bought by an investor. In such a case, the buyer will have to take up the debt of the organisation too. The inclusion of debt is something which gives the enterprise value its added advantage for the purpose of organisation value representation.
The most commonly used multiples of EV are –
It takes into account the enterprise value which can further be compared with the sales of the company. It can be very helpful when there are significant differences in accounting policies of the companies and can be used for companies with negative free cash flows or unprofitable companies. If EV/sales are higher, then it means that the company is costlier and it’s not a good bet for investors to invest into because they won’t be getting any immediate benefit out of this investment. If EV/sales are lower, then it is considered to be a great investment opportunity for investors.
The values of EV and EBITDA are used in order to find EV/EBITDA ratio of an organisation and this metric is widely used to analyse and measure an organisation’s RoI i.e. return of investment as well as its value. It’s a much better metric than the market cap for mergers & acquisitions (M&A).
A low EV/EBITDA ratio value indicates that a particular organisation may well be undervalued while a high EV/EBITDA ratio value indicates that the organisation may well be overvalued.