Enterprise Value (EV) – Formula, Definition and Examples of EV

The formula for calculating enterprise value is:

EV = Market Capitalization + Debt + Minority Interest + Preferred Shares – Cash & Cash Equivalents

Market Cap: 

• Short for market capitalization. This metric is calculated by multiplying shares outstanding
• This number can fluctuate as share prices go up or down and as the number of shares outstanding changes based upon various corporate actions such new issues via secondary offerings, share buybacks, and employees of a company exercising their stock options. 

Debt:

• Money lent to a company by a lender that requires interest payments to beshort term debt
• The more debt a company holds, the higher the EV will be. Likewise the less debt a company holds, the lower the EV will be. 
• If an analyst is unable to identify the market value book value of a company’s debt as an alternative.

Minority Interest: 

• Represents a non controlling interest
• Minority interest within the EV formula accounts for the value of the small shareholders who have no control over the company. 
• By including this measure within the EV calculation, we are able to come to a more accurate conclusion on the true value of a firm. 

Preferred Shares:

• Equities that come with special benefits such as dividend payments and a higher rank in the liquidation process if a company is being dissolved. 
• These types of shares offer both the benefits that you would get from holding common stock (through a share in dividends) and from holding a fixed income

Cash and Cash Equivalents: 

• It includes short term financial instruments on top of already available cash. 
• These short term financial instruments are highly liquid money market
• Cash Equivalents include marketable securities, commercial paperrepo agreements, and treasury bills.  

Using enterprise value to measure the value of a company allows an investor to make an apples to apples comparison between two companies with different capital structures. 

Let’s say there are two companies A and B with similar revenue and net income but Company A has significantly more debt than Company B. 

Using net income and market cap leads us to believe that Company A has a higher value than company B (the result of employing financial leverage).

However, by using EV and EBITDA instead of market capitalization and net profit, you can see that Company A is not really better off than Company B because it has more debt while producing the same amount of revenue and net income. 

In the above example, Company A and Company B both have the same revenue and the same net income. They both have the same market capitalization as well. 

Company A has $15 million in short term debt and $30 million in long term debt resulting in $45 million in total debt. 

Company B has $200 thousand in short term debt and $1.2 million in long term debt resulting in 1.4 million in total debt. 

This difference in capital structure leads Company A to be 43.6 million dollars more expensive than Company B despite the fact that both companies have the same market cap with the same revenue and net income. 

Just because Company A is equally profitable to Company B while employing more debt doesn’t necessarily make Company A an undesirable target for acquisition. Considering the fact that Company A has $45 million in total debt while producing the same net income as Company B can indicate that the management of Company A is not using its capital as efficiently as it could be. 

If an acquirer were to implement new procedures and policies to alter this dynamic, Company A could theoretically become far more profitable via efficient and effective use of its available capital. 

Let’s take a look at another example which will highlight why using EV is important. Company 123 has 150 million outstanding shares at a share price of $50. This results in Company 123 having a market capitalization of $7.5 billion.  Meanwhile by using EV to find Company 123’s true value, we find that it should be valued at 8.2 billion. 

The present value of Company 123’s short term debt is $200 million and its long term debt is $1.5 billion resulting in total debt of $1.7 billion. The company has $750 million in cash and $250 million in cash equivalents which equals $1 billion in cash and cash equivalents (CCE).

The reason for subtracting CCE is the idea that CCE can be used to pay off debt instantly which reduces the amount of debt by an equivalent amount.

We add short term and long term debt and then we subtract CCE. Had we used market capitalization to find Company 123’s value we would have excluded short term debt, long term debt, and CCE from our evaluation. 

This inclusion of additional key financial items in the valuation process is what makes EV such a significant and popular metric. While market capitalization accounts for the equity value of a company, EV accounts for both the equity value and the capital structure of a company.

One of the most common uses of enterprise value is to use it within a valuation multiple. 

The most popular multiple is EV / EBITDA and involves dividing the company’s EV by it’s EBITDA (earnings before interest, tax, depreciation and amortization). This valuation multiple allows you to compare across multiple different companies. 

Other common EV multiples include EV/EBIT, EV/Revenue, and EV/EBITDAR.

EV/EBITDA

• This valuation multiple is calculated as EV divided by EBITDA. It is the most common and widely used valuation multiple that involves EV.
• This metric allows investors to compare and contrast returns from comparable companies
• Using EBITDA as a metric for analysis offers investors the opportunity to perceive earnings unaffected by debt costs and depreciation and amortization expenses.  

EV/EBIT

• Calculated as enterprise value divided by earnings before interest and taxes. 
• EBIT is similar to EBITDA with the exception of including depreciation and amortization. 
• This ratio can be great for analyzing whether an equity is overvalued or undervalued

EV/Revenue

• This valuation multiple is calculated as EV divided by revenue. 
• It can increase difficulty in comparing across companies because different businesses have different revenue recognition philosophies which
• EV/Revenue is a fantastic valuation multiple for companies that are in their early stages. Early stage growth companies are often unprofitable or breaking even. Because of this dynamic, EV/EBITDA cannot be used because there are no earnings to account for. 

EV/EBITDAR

• This valuation multiple includes EBITDAR which stands for earnings before interest, taxes, depreciation and amortization, and rental costs/restructuring costs. This multiple is calculated by taking EV and dividing it by EBITDAR. 
• This is a great multiple to use for comparing companies within the hospitality, transportation, or restaurant industries. Companies within these industries often have high rental costs which need to be accounted for. 
• EBITDAR can also be a great multiple for comparing companies that have recently incurred a large amount of restructuring costs.

One thing you might wonder about enterprise value is why cash gets deducted. The idea behind this concept is that if a company has enough assets or liquid assets, they can pay back their debts with them instead of having to take out another loan – which would make the EV bigger than it actually is.

By deducting cash, what’s left over will be the total value of the company plus any liquid assets that are available. That way, you’re getting a better picture of what the company would be worth if it lused its liquid assets to pay off its debts.

Another reason for deducting cash is that companies don’t look more valuable than they really are just because they have lots of liquid assets on hand. If we were to not deduct cash, then two companies with comparable capital structures, revenue, and net income may have entirely different values if one company has chosen to keep a large amount of cash available. 

One exception to this rule is when a company has negative cash flow. If a company has negative cash flow then instead of subtracting cash, any cash on hand should be added to the EV because it is an asset. In addition, if a company has negative earnings, it may be more useful to use discounted cash flow analysis to value a company because it will allow you to measure the value of expected future cash flows.

Meanwhile if a company were to have too much cash on hand, this would result in a negative EV. This scenario arises when a company has more than enough cash to purchase all of its outstanding shares and pay off all of its debt. 

While EV can be a fantastic metric for determining a company’s value and potential target acquisition price, it can as well come with some limitations. Below are a few of the potential issues that can arise when using it.

• It only takes into account the assets and liabilities that are on the balance sheet. If a company has off-balance sheet debt then those items will not be included within the EV formula. Common items that are left off of the balance sheet include pension obligations and leases. Within the acquisition process it is important to review a company’s 10k to look for various off balance sheet
• It does not take into account changes in interest rates or credit ratings. This can be problematic if there’s been an adverse change in either of those factors because it could significantly affect the company’s outlook and might even lead to bankruptcy.
• It may not be the best valuation metric when analyzing startups and early stage growth companies. Oftentimes the value of these types of companies derives from the expected value of the company’s potential future cash flows. When analyzing a company that is still in the early stages of growth, a discounted cash flow model may be better for deriving company value.
• It can vary drastically across different industries. Some industries require businesses to maintain capital structures that incorporate a large amount of debt. This usually includes industries that revolve around gasoline and oil. In addition, any business that requires consistently large capital expenditures towards property, plant, and equipment will likely require a company to undertake a large amount of debt.