Enterprise value (EV), total enterprise value (TEV), or firm value (FV) is an economic measure reflecting the market value of a business (i.e. as distinct from market price). It is a sum of claims by all claimants: creditors (secured and unsecured) and shareholders (preferred and common). Enterprise value is one of the fundamental metrics used in business valuation, financial analysis, accounting, portfolio analysis, and risk analysis.

Enterprise value is more comprehensive than market capitalization, which only reflects common equity.[1] Importantly, EV reflects the opportunistic nature of business and may change substantially over time because of both external and internal conditions. Therefore, financial analysts often use a comfortable range of EV in their calculations.

EV equation

For detailed information on the valuation process see Valuation (finance).

Enterprise value =
common equity at market value (this line item is also known as "market cap")
+ debt at market value (here debt refers to interest-bearing liabilities, both long-term and short-term)
+ minority interest at market value, if any
+ preferred equity at market value
+ unfunded pension liabilities and other debt-deemed provisions
– value of associate companies
– cash and cash equivalents.

Understanding

A simplified way to understand the EV concept is to envision purchasing an entire business. If you settle with all the security holders, you pay EV. Counterintuitively, increases or decreases in enterprise value do not necessarily correspond to "value creation" or "value destruction". Any acquisition of assets (whether paid for in cash or through share issues) will increase EV, whether or not those assets are productive. Similarly, reductions in capital intensity (for example by reducing working capital) will reduce EV.

EV can be negative if the company, for example, holds abnormally high amounts of cash that are not reflected in the market value of the stock and total capitalization.[2]

All the components are relevant in liquidation analysis, since using absolute priority in bankruptcy all securities senior to the equity have par claims. Generally, also, debt is less liquid than equity, so the "market price" may be significantly different from the price at which an entire debt issue could be purchased. In valuing equities, this approach is more conservative than using the "market price".

Cash is subtracted because it reduces the net cost to a potential purchaser. The effect applies whether the cash is used to issue dividends or to pay down debt.

Value of minority interest is added because it reflects the claim on assets consolidated into the firm in question.

Value of associate companies is subtracted because it reflects the claim on assets consolidated into other firms.

EV should also include such special components as unfunded pension liabilities, employee stock options, environmental provisions, abandonment provisions, and so on since they also reflect claims on the company.

There are certain limitations and traps in using enterprise value. One of which can be a simplified aggregation of company's financial situation. One unit of additional debt may not be of same importance as additional one unit of missing cash.[3]

It can be demonstrated that enterprise value depends on the probability of default (the rating) and works as a "negative growth rate" in the future.[4]

Usage

Technical considerations

Data availability

Unlike market capitalization, where both the market price and the outstanding number of shares in issue are readily available and easy to find, it is virtually impossible to calculate an EV without making a number of adjustments to published data, including often subjective estimations of value:

In practice, EV calculations rely on reasonable estimates of the market value of these components. For example, in many professional valuations:

Avoiding temporal mismatches

When using valuation multiples such as EV/EBITDA and EV/EBIT, the numerator should correspond to the denominator. In other words, the profitability metric in the denominator should be available to all stakeholders represented in the numerator. The EV should, therefore, correspond to the market value of the assets that were used to generate the profits in question, excluding assets acquired (and including assets disposed) during a different financial reporting period. This requires restating EV for any mergers and acquisitions (whether paid in cash or equity), significant capital investments or significant changes in working capital occurring after or during the reporting period being examined. Ideally, multiples should be calculated using the market value of the weighted average capital employed of the company during the comparable financial period.

When calculating multiples over different time periods (e.g. historic multiples vs forward multiples), EV should be adjusted to reflect the weighted average invested capital of the company in each period.[note 1]

See also

Notes

  1. ^ This is analogous to the way earnings per share (net income / weighted average number of shares) is influenced by changes in the number of shares over different financial years.

References

  1. ^ Definition of 'Enterprise Value - EV'
  2. ^ Cheapest Stocks Since 1995 Show Cash Exceeds Market (Update5)
  3. ^ What is enterprise value (EV)
  4. ^ Gleißner, Werner. "Kapitalmarktorientierte Unternehmensbewertung: Erkenntnisse der empirischen Kapitalmarktforschung und alternative Bewertungsmethoden". Corporate Finance: 158.