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Enterprise Value Definition and Calculation

The term enterprise value is frequently encountered in the financial literature. This article provides some basics about enterprise value which will help you to understand how it is calculated the next time you see it in an annual report.

Enterprise value is needed for the estimation of the whole cost of a company you should pay in order to become its owner. Due to the inclusion of such factors as debt, preferred stock and cash reserve, enterprise value is a more preferred method of estimation of takeover cost than market capitalization.

Enterprise Value Estimation

There are two different methods for estimating the enterprise value. The first one involves the following simple formula:

number of shares outstanding x current share price = enterprise value

This method is a bit too simplistic and not rigorous enough and for this reason it is less preferred by analysts for enterprise value estimation. A more thorough approach adds market capitalization, debt, preferred stock and cash and cash equivalents to the equation. The following formula is used:

market capitalization + preferred stock + outstanding debt - cash & equivalents = enterprise value

As it can be seen from the way an enterprise value is calculated, it can be concluded that the latter represents the costs that you will incur if you want to purchase all of the company's common stock, outstanding debt and preferred stock. The cash is subtracted since having purchased the mentioned above shares, you gain full ownerships which automatically makes you a holder of the company's cash.

Enterprise Value Components

When a company is about to be acquired, its new owner takes on debt (which sometimes can be quite substantial) as well as assets, cash and liquid assets. The more complex formula for enterprise value estimation is more accurate namely because it recognizes that all these factors contribute to value.

  • Preferred stock can take different functions depending on the specific circumstances. Two of the possibilities are performing as equity or debt. Debt is characterized by the existence of a determined date and price at which a preferred issue should be paid back. Additionally, preferred stocks include the possibility of earning both a fixed dividend and a percentage of the gained profits, known as participating. Whatever the functions of preferred stocks, their availability requires their inclusion in the enterprise value calculations.
  • Market capitalization is the total market value of a company. The following formula is used for its calculation:

    market capitalization = number of shares outstanding x current price per share

    To clarify, consider the following example. Your company includes 1,500,000 shares of outstanding stock. The current price for one stock is $20 for a share. Therefore, the market cap of your company is $30 million (multiply the number of outstanding shares by their price).

  • Debt represents the owing of the company. For example, you have acquired the outstanding shares of a shoe factory by paying $10 million, which represents the market cap of the company. Throughout its activities, the shoe factory has incurred $3 million in the form of debt. Therefore, you have acquired $13 million. You are responsible for repaying the $3 million in addition to the $10 million you should pay for the acquisition of the factory. The $3 million will be taken out of the company's cash flow, which otherwise could have been allocated for other activities.
  • Cash and cash equivalents become your possession and responsibility with the acquisition of a particular business. You can compensate the costs you have incurred for purchasing the business by withdrawing the specific holdings from the bank. The cash and cash equivalents are subtracted when computing the enterprise value since they have a reduction effect on the price for which you have acquired the business.

Importance of Value Enterprise

When deciding whether to purchase a particular business potential buyers compare the enterprise with the cash flow that it generates. If the cash flow represents a big portion of the company's enterprise value, than it is regarded as a preferred purchase. Such investments require little additional investment. As a result, the cash in the company's bank account can be withdrawn and reinvested into other financial opportunities.

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