This post will take a dive into the enterprise value concept – an important concept in private business valuations.
As its name suggests, enterprise value is the measure of a company’s total value – it includes all asset claims and ownership interests from both, debt, and equity holders – thus, enabling an investor to compare companies with different capital structures. Hence, the enterprise value can be thought of as the effective cost of buying a business (excluding takeover premiums).
Enterprise value (EV) can be calculated as follows:
EV = Market Capitalization + Preferred Shares + Market Value of Debt +Minority Interest – Cash and Cash Equivalents
Components of Enterprise Value:
- Equity Value (Market Capitalization) – A company’s equity value is calculated by taking the company’s fully diluted shares and multiplying it by a stock’s current market price. One must note that fully diluted shares include in-the-money options, warrants, and convertible securities, aside from just the basic shares outstanding.
- Market Value of Debt – Debt includes interest-bearing liabilities such as short-term and long-term debt. The amount of debt gets adjusted by subtracting cash from it because, in theory, when a company has been acquired, the acquirer can use the target company’s cash to pay a portion of the assumed debt. If the market value of debt is unknown, the book value of debt can be used instead.
- Preferred Stock – are hybrid securities that have features of both equity and debt. In this case, they are treated more as debt, because they pay a fixed amount of dividends and have a higher priority in asset and earning claims than common stock.
- Minority Interest or Noncontrolling Interest – This refers to the part of the subsidiary that is not owned by the parent company. When calculating the enterprise value of the parent company, we include minority interests as the parent company has consolidated financial statementswith that minority interest; meaning the parent includes 100% of the revenues, expenses, and cash flow in its numbers even though it doesn’t own 100% of the business as per U.S. Accounting rules.
- Cash and Cash Equivalents – Cash and Cash Equivalents represent the most liquid assets on a company’ balance sheet. Examples of cash equivalents are short-term investments, marketable securities, commercial paper, and money market funds. We subtract this amount from the enterprise value because it will reduce the acquiring costs of the target company. It is assumed that the acquirer will use the cash to immediately pay a dividend or pay off debt.
Company ABC’s financial information is as follows:
- Shares outstanding – 200,000
- Market value per share – $4.5
- Market value of debt – $30,000
- Cash and cash equivalents – $75,000
- Minority Interest – $130,000
- Preferred Stock – $0
We know that Company ABC’s market capitalization is as follows :
= Shares outstanding X Market value per share
=200,000 X $4.5
Thus, we now calculate Company ABC’s enterprise value using the following formula:
Enterprise Value (EV) = Market Capitalization + Preferred Shares + Market Value of Debt +Minority Interest – Cash and Cash Equivalents.
EV = $900,000 + $0 + $30,000 + $130,000 – $75,000
EV = $985,000