Calculate the transaction value of a theoretical company based on the information provided below

What Is Enterprise Value (EV)?

Enterprise value (EV) measures a company's total value, often used as a more comprehensive alternative to equity market capitalization. EV includes in its calculation the market capitalization of a company but also short-term and long-term debt and any cash or cash equivalents on the company's balance sheet.

Key Takeaways

• Enterprise value (EV) measures a company's total value, often used as a more comprehensive alternative to equity market capitalization.
• Enterprise value includes in its calculation the market capitalization of a company but also short-term and long-term debt and any cash on the company's balance sheet.
• Enterprise value is used as the basis for many financial ratios that measure a company's performance.

Introduction To Enterprise Value

Components of Enterprise Value (EV)

Enterprise value uses figures from a company's financial statements and current market prices. The components that make up EV are:

• Market cap: The total value of a company's outstanding common and preferred shares
• Debt: The sum of long-term and short-term debt
• Unfunded pension liabilities (if any): The amount of capital lacking to cover pension payouts or the amount a company needs to set aside to make pension payments in an unfunded plan. Can be added market cap if this value is present.
• Minority interest: The equity value of a subsidiary with less than 50% ownership. It can be added to market cap for EV calculation.
• Cash and cash equivalents: The total amount of cash, certificates of deposit, drafts, money orders, commercial paper, marketable securities, money market funds, short-term government bonds, or Treasury bills a company possesses.

Enterprise Value (EV) Formula and Calculation

E V = M C + T o t a l   D e b t − C where: M C = Market capitalization; equal to the current stock price multiplied by the number of outstanding stock shares T o t a l   d e b t = Equal to the sum of short-term and long-term debt C = Cash and cash equivalents; the liquid assets of a company, but may not include marketable securities \begin{aligned} &EV=MC+Total~Debt-C\\ &\textbf{where:}\\ &MC=\text{\small Market capitalization; equal to the current stock}\\ &\text{\small price multiplied by the number of outstanding stock shares}\\ &Total~debt =\text{\small Equal to the sum of short-term and}\\ &\text{\small long-term debt}\\ &C=\text{\small Cash and cash equivalents; the liquid assets of}\\ &\text{\small a company, but may not include marketable securities}\\ \end{aligned} ​EV=MC+Total Debt−Cwhere:MC=Market capitalization; equal to the current stockprice multiplied by the number of outstanding stock sharesTotal debt=Equal to the sum of short-term andlong-term debtC=Cash and cash equivalents; the liquid assets ofa company, but may not include marketable securities​

To calculate market capitalization—if not readily available online—you would multiply the number of outstanding shares by the current stock price. Next, total all debt on the company's balance sheet, including both short-term and long-term debt. Finally, add the market capitalization to the total debt and subtract any cash and cash equivalents from the result.

What Does EV Tell You?

Enterprise value (EV) differs significantly from simple market capitalization in several ways, and many consider it to be a more accurate representation of a firm's value. EV tells investors or interested parties a company's value and how much another company would need if it wanted to purchase that company.

There is one other consideration: a company's EV can be negative if the total value of its cash and cash equivalents surpasses that of the combined total of its market cap and debts. This is a sign that a company is not using its assets very well—it has too much cash sitting around not being used. Extra cash can be used for many things, such as distributions, buybacks, expansion, research and development, maintenance, employee pay raises, bonuses, or paying off debts.

Market capitalization is not intended to represent a company's book value. Instead, it represents a company's value as determined by market participants.

EV as a Valuation Multiple

Enterprise value is used as the basis for many financial ratios that measure the performance of a company. For example, the enterprise multiple contains enterprise value. It relates the total value of a company from all sources to a measure of operating earnings generated—the earnings before interest, taxes, depreciation, and amortization (EBITDA).

EBITDA measures a company's ability to generate revenue and is used as an alternative to simple earnings or net income (in some circumstances). EBITDA, however, can be misleading because it strips out the cost of capital investments like property, plant, and equipment. Another figure, EBIT, can be used as a similar financial metric without the drawback of removing depreciation and amortization expenses related to property, plant, and equipment (PP&E).

EBITDA Calculation

EBITDA is calculated using the following formula:

EBITDA = Net Income + Interest Expense + Taxes + Depreciation + Amortization

EV/EBITDA

The enterprise multiple (EV/EBITDA) metric is used as a valuation tool to compare the value of a company and its debt to the company’s cash earnings, less its non-cash expenses. As a result, it's ideal for analysts and investors looking to compare companies within the same industry.

EV/EBITDA is useful in several situations:

• The ratio may be more useful than the P/E ratio when comparing firms with different degrees of financial leverage (DFL).
• EBITDA is helpful in valuing capital-intensive businesses with high levels of depreciation and amortization.
• EBITDA is usually positive even when earnings per share (EPS) is not.

EV/EBITDA has a few drawbacks:

• If working capital is growing, EBITDA will overstate cash flows from operations (CFO or OCF). Further, this measure ignores how different revenue recognition policies can affect a company's OCF.
• Because free cash flow to the firm captures the number of capital expenditures (CapEx), it is more strongly linked with valuation theory than EBITDA. EBITDA will be a generally adequate measure if capital expenses equal depreciation expenses.

EV/Sales

Another commonly used multiple for determining the relative value of firms is the enterprise value to sales ratio or EV/sales. EV/Sales is regarded as a more accurate measure than the Price/Sales ratio since it considers the value and amount of debt a company must repay at some point.

It's believed that the lower the EV/Sales multiple, the more attractive—or undervalued—the company is. The EV/Sales ratio can be negative when the cash held by a company is more than the market capitalization and debt value. A negative EV/sales implies that a company can pay off all of its debts.

Enterprise Value vs. Market Cap

Why doesn't market capitalization properly represent a firm's value? It leaves a lot of essential factors out, such as a company's debt and cash reserves.

Enterprise value is a modification of market cap, as it incorporates debt and cash for determining a company's value.

Here's an example: imagine two identical widget manufacturers, Company A and Company B, have the same stock price of $4.32 per share. Each have 1 million outstanding shares with a market cap of $4.32 million.

Debt and Cash Change the View

Now, imagine Company A has $500,000 in cash and cash equivalents and $250,000 in total debt. Its EV (total worth) is $4,320,000 + $250,000 - $500,000 = $4.07 million.

Company B has $1 million in cash and $250,000 in debt. It's EV is $4,320,000 + $250,000 - $1,000,000 = $3.57 million.

The companies looked identical using market cap, but a much different picture appears when EV is calculated.

Enterprise Value vs. P/E Ratio

The price-to-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its current share price relative to its earnings per share (EPS). The price-to-earnings ratio is sometimes known as the price multiple or the earnings multiple. The P/E ratio doesn't consider the amount of debt that a company has on its balance sheet.

EV includes debt when valuing a company and is often used in tandem with the P/E ratio to achieve a comprehensive valuation.

Limitations of EV

As stated earlier, EV includes total debt, but it's essential to consider how the company's management utilizes the debt. For example, capital-intensive industries such as the oil and gas industry typically carry significant amounts of debt, which is used to foster growth. The debt could have been used to purchase a plant and equipment. As a result, the EV can be skewed when comparing companies across industries.

This is essential to consider if the company being looked at is undergoing a merger or acquisition. This is because the acquiring company will need to account for the amount of debt it is taking on in the merger. Investors can use this information to evaluate what the merged companies will look like in the future.

As with any financial metric, it's best to compare companies within the same industry to better understand how the company is valued relative to its peers.

Example of EV

As stated earlier, the formula for EV is essentially the sum of the market value of equity (market capitalization) and the market value of a company's debt, less any cash. A company's market capitalization is calculated by multiplying the share price by the number of outstanding shares. The net debt is the market value of debt minus cash. A company acquiring another company keeps the cash of the target firm, which is why cash needs to be deducted from the firm's price as represented by the market cap.

Let's calculate the enterprise value for Macy's (M). For its 2021 fiscal year, Macy's recorded the following:

We can calculate Macy's market cap from the information above. Macy's has 292.4 million outstanding shares valued at $25.44 per share at the end of its fiscal year (Jan. 29, 2022):

• Macy's market capitalization was $7.44 billion (292.4 million x $25.44).
• Macy's had short-term debt of $0 and long-term debt of $3.30 billion for a total debt of $3.30 billion.
• Macy's had $1.71 billion in cash and cash equivalents.

Macy's enterprise value is calculated as $7.44 billion (market cap) + $3.30 billion (debt) - $1.71 billion (cash).

Macy's EV = $9.03 billion

Enterprise value is considered comprehensive when valuing a company because, if a company were to purchase Macy's outstanding shares for $7.44 billion, it would also have to settle Macy's $3.30 billion in outstanding debts.

In total, the acquiring company will spend more than $10 billion to purchase Macy's. However, since Macy's has $1.71 billion in cash, this amount could be added to repay the debt.

How Do You Calculate Enterprise Value?

Take the number of outstanding shares from a company's balance sheet and multiply it by the current share market price. Then, subtract the value of cash and cash equivalents (also found on the balance sheet), and you have its EV.

What Is a Good Enterprise Value?

Enterprise value is a good indicator of a company's total value, but the EV/EBITDA is a better indicator, demonstrating the total value to actual earnings. An EV/EBITDA below 10 is considered healthy.

What Is Enterprise Value and Why Is it Important?

Enterprise value shows a company's total value and is generally used in mergers and acquisitions to valuate a prospect.

What Is Enterprise Value vs. Market Value?

Enterprise value is the total value of a company, while market value is the value of its shares on the stock market. Market capitalization is the total value of all sthares on the stock market.

The Bottom Line

Enterprise value estimates a company's total value, generally used by other companies when considering a merger or acquisition. Investors can also use EV to estimate a company's size and worth to help them evaluate their stock choices.

EV is best used with other metrics for valuating a stock. Some popular ratios are EV/Sales and EV/EBITDA,

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