Enterprise value (EV) is a method of valuing businesses that is often used in mergers and acquisitions (M&A). For a company to calculate its EV, it must add its market capitalisation (the value of its publicly traded shares) and subtract highly liquid assets, such as cash and savings. In todays guide, we will discuss in detail what EV is and why it's so important. Let's get started.

What Is Enterprise Value (EV)?

An enterprise value (EV) can be defined as a method for valuing a business or determining the value of a company. A business valuation may be based on the profitability of the company or the likelihood of generating a high return for investors in the future. The EV, on the other hand, provides a measure of a business's value based on its purchase price. An enterprise value illustrates the cost of buying a public company, which requires paying off all of the debts and buying out all of its shareholders.

Business valuation methods based on capital structure or debt/equity ratios are especially useful when comparing companies of different sizes or capital structures. The EV is calculated by taking the total debt and equity of the company and adding them together, making it possible to compare varying debt-to-equity ratios on a more equal basis.

What is The Purpose of Enterprise Value?

In mergers and acquisitions, enterprise value is a key methodology for valuing the company. Investment banks assist their clients in deciding whether buying or merging with another company will benefit them in M&A.

In addition to using EV in corporate finance and accounting calculations, the metric is also used in other formulas and calculations. The enterprise value is used, for instance, to create a relative value of companies to compare with EBITDA (earnings before interest, taxes, depreciation, and amortization).

Calculating Enterprise Value

During the calculation of enterprise value, the company's cash or liquid assets (excluding stocks and other securities) are subtracted from its total debt and market capitalization.

Enterprise Value Formula:

EV = Market Cap + Total Debt Cash

Main Parts of EV Calculation

Here are 3 main parts of EV calculation you need to know about:

• Market Cap

A company's market capitalization reflects the current market value of its shares in use or the number of shares issued to shareholders. The market capitalization of a company is calculated by multiplying the total number of shares held by the current market price of the shares. According to this metric, the more significant a company is the higher its market capitalization.

• Total Debt of Company

Total debt refers to all the money a company owes to its creditors or lenders. There are both short-term and long-term debts included in this category. Alternatively, debt may be referred to as liabilities - the amount of money owed to others by a business.

• Cash

Generally, cash consists of paper currency, savings accounts, and checking accounts of the company. Even though stocks are liquid assets, marketable securities do not fall under this category since their value is included in market capitalization or equity value.

The net debt of a company can be calculated by subtracting cash from the total debt of the company - if you inherit the company's liquid assets in addition to the cash, this can serve to offset some of the total debt, resulting in only net debt.

Valuation Multiples Based on EV

The enterprise value of a company is used to calculate many financial ratios that measure its performance. For instance, enterprise value can be found in the enterprise multiple.

EBITDA

EBITDA measures the income of a company, excluding interest, taxes, depreciation, and amortization.

In some cases, EBITDA is used instead of simple earnings or net income to measure a company's ability to generate revenue. The EBITDA figure can be misleading, however, since it does not include capital investment costs such as property, plant, and equipment. Alternatively, EBIT can perform the same function without the disadvantage of excluding depreciation and amortization expenses associated with property, plant, and equipment (PP&E).

EV/Sales

Another variable commonly used to determine relative value of a company is the enterprise value-to-sales ratio, or EV/S. A company's EV-to-sales ratio is considered to be a more accurate measure than its price-to-sales ratio since it takes into account the amount and value of debt that it will have to pay back at a later time.

There is a general belief that a company's value (underappreciation) increases with a lower EV/sales multiple. When the company's cash is greater than its market capitalization and debt, the EV/sales ratio may be negative. If a company has a negative EV/sales ratio, it indicates that it has enough cash to pay off all of its debts.

P/E Ratio vs. Enterprise Value

Price-to-earnings ratios (P/Es) are used to evaluate a company's value by comparing its current share price with its earnings per share. Price-to-earnings ratios may also be referred to as price multiples or earnings multiples. The P/E ratio does not take into account the amount of debt on a company's balance sheet.

What Are the Limitations of EVs?

The EV of a company includes debt, but it's important to consider how the debt is utilized by management. An oil and gas industry, for instance, typically carries significant amounts of debt in order to facilitate growth. There was the possibility of using the debt to purchase a plant and equipment. Thus, comparing companies across industries can result in inaccurate EVs.

A merger or acquisition of the company under consideration requires consideration of this factor. Because of the debt that the acquiring company will be taking on in the merger, it is necessary for it to account for the debt. Using this information, investors will be able to evaluate the future prospects of the merged companies.

For a better understanding of how a company is valued in comparison to its peers, it is helpful to compare companies within the same industry.

Conclusion

The enterprise value of a company is an estimate of the total value of the company, and it is usually used when another company considers merging or acquiring the company. It is also possible for investors to use EVs to estimate a business's size and value in order to help them evaluate the stocks they are considering. The EV is best used in conjunction with other metrics when valuing a stock. There are a number of popular ratios, including EV/sales and EV/EBITDA.