Enterprise Value

You may come across the world Enterprise Value several times while going through the newspapers, magazines and financial reports of the companies. You may wonder what this is and how it’s calculated and why it’s so important.

Simple definition of Enterprise Value is Total Cost of company. This more accurate estimate of takeover cost than market capitalization because it takes includes a number of important factors such as preferred stock and cash reserves that are excluded from the latter metric.

How Enterprise Value is calculated?

Enterprise value is calculated by adding a company’s market capitalization, preferred stock and outstanding debt together and then subtracting out the cash and cash equivalents found on the balance sheet. In other words enterprise value is what it would cost you to buy every single share of a company’s common stock, preferred stock, and outstanding debt. The reason the cash is subtracted is simple: once you have acquired complete ownership of the company, the cash becomes yours.

Lets Have a look at those individual terminology used above.

Market Capitalization:
Market Capitalization is calculated by taking no of outstanding shares of common stock multiplied by the current market price of the shares.
E.g.: If ABC Corporation has 1000000 (lacs) shares outstanding and current market price of the share is Rs 75 the market capitalization of the ABC Corporation would be 75000000.( Stock 1000000*75 price per share)

Preferred Stock
Preferred stock can act as debt or equity depending upon the nature of issue. A preferred issue must be redeemed at a certain date at a certain price. In other cases, preferred stock may have the right to receive a fixed dividend plus share in a portion of the profits (this type is known as “participating”).

Debt:
Once you purchase a business the debts owned by the business comes along with you. So you become responsible for that debt of the business. If you are buying XYZ corporations outstanding shares of Rs 50, 00,000(market capitalization value) and business may have the debt of Rs 10, 0,000 then you are expended to Rs 60, 00,000. Today 50, 00,000 may come out of your pocket but you are now responsible for paying 10, 00,000 out of the cash flow of the business.

Cash and Cash Equivalents:
Once you’ve purchased a business, you own the cash that is sitting in the bank. After acquiring complete ownership, you can simply take this cash and put it in your pocket, replacing some of the money you expended to buy the business. In effect, it serves to reduce your acquisition price; for that reason, it is subtracted from the other components when calculating enterprise value.

Why Is Enterprise Value Important?
Some investors, particularly those that follow a value philosophy, will look for companies that are generating a lot of cash flow in relation to enterprise value. Businesses that tend to fall into this category are more likely to require little additional reinvestment; instead, the owners can take the profit out of the business and spend it or put it into other investments.

From: Kedar Gogate. N
IBS Chd 08