What is an Enterprise Value
Valuing business is rather complex than it usually seems. It is often perplexing as to which yardstick to apply to calculate the buy-off value for a firm. And what tool is best to assess the value of a start-up venture or an established company, or a heavy debt ridden or a company with huge market capitalization?
Investment bankers often rely on tested tools to determine intrinsic value of a firm’s business. Enterprise value is a comprehensive measure of economic value of a business. Referring to only market capitalization has its limitations, as it overlooks other elements. Enterprise Value arrives at the acquiring cost of a firm considering various other elements in a balance sheet like preferred stock, debt and cash.
In mathematical equation, Enterprise Value is calculated by adding the market capitalization with preferred stock and total outstanding debt while subtracting cash or its equivalent. Let’s examine each of these elements closely with logic. Market Capitalisation represents the current value of the company by aggregating the price people are willing to pay for each share of the company. It is calculated by multiplying total number of outstanding shares with current market price per share.
For E.g: If a company has 5 lakh stock outstanding with a current market price of 100 per share, then the total market capitalization works out to 5 crores (5,00,000 x Preferred stock are redeemable at a certain date for a certain price.
Preferred stock also commands a fixed dividend or share in profits. Since it is a claim on future business which needs to be paid off eventually, the preferred stock is factored in to determine the enterprise value. Total Debt refers to both long-term and short-term debt. It is already invested in the business and needs to be paid off by the buyer. With a heavy debt ridden company, the buyer will have to keep making interest and principal payments in the future. Hence debt needs to be factored as a cost to the business.
Once you acquire the firm, you also acquire its other quick assets like cash and cash equivalents. One can assume this cash as a replacement of the initial money that a buyer shells out or simply pay off some or all of the outstanding debts. In effect cash and its equivalents sets off against the overall buy price hence subtracted from other components which calculating overall enterprise value.
Overall company’s financial health in terms of stock price, debt and free cash reserves makes a huge difference in determining the company’s value with Enterprise Valuation method.