Enterprise Value (EV) of a Business: Concept and Importance

Prabhat Nigam

10 Sep, 2022

The concept of Enterprise value has become one of the key aspects of business valuation these days instead of equity market capitalisation. Enterprise value serves as a foundation for mergers and acquisition deals taking place these days. There are several reasons why enterprises are looking for EV over other forms of valuation. To understand the concept of EV, one has to delve deeper into concept. 

This piece of writing discusses the concept of Enterprise Value and its importance for a business.

What is the concept of Enterprise Value?

In simple words, enterprise value^[1] is the financial metric for calculating a company’s total value, including both equity and debt holdings. EV represents the entire market value instead the equity value. For instance, let’s consider a house on mortgage. The Enterprise value of the house is the market value of the house as a whole, while the market capitalisation of the house would be the sum of the outstanding mortgage and its value.         

What are the constituents of Enterprise Value?

The key constituents of Enterprise value are as follows:

1. Equity value: the equity value of a company is determined by multiplying the fully diluted shares by the stock’s current price. It includes the warrants and convertible securities besides the basic shares standing.
2. Preferred Stock: these comprise hybrid securities having features of both equity and debt. Irrespective of this fact, preferred stock is considered a debt constituent of EV because these stocks pay out a fixed amount of dividends and are given priority over common stocks. In the case of an acquisition, they hold precedence for paying them off over common stock.
3. Total debt comprises the total contribution made to the creditors and financial institutions. Total debt comprises both long-term and short-term debt. This debt value is adjusted by deducting cash because, at the time of acquisition of a company, the company’s cash is first used to pay off the debt.
4. Minority interest: it includes those subsidiaries which are not owned by the parent company but are consolidated in the financial report of the parent company. Minority interest is added in the calculation of EV because its cash flows form part of the total revenues generated by the parent company.
5. Cash and cash equivalents: this component comprises commercial papers, short-term investments, marketable securities etc., which are then subtracted from the EV because they lower the acquiring cost of the company.

Formulae for calculating the Enterprise Value

There are two formulae for determining the EV of a company. These are as follows:

• The simple formula to calculate

EV= Market Cap. + Market Value of Debt – Cash and Equivalents; OR

• The extended formula for EV calculation

EV= Common shares + Preferred Shares + Market Value of Debt + Minority Interest – Cash and Equivalents

Market Cap = No. of outstanding shares * Current stock price + Company’s debts (both long-term and short-term debts)

Importance of Enterprise Value   

The importance of the concept of Enterprise value has been discussed as follows:

• To find the Worth of a company: EV helps the business entities in determining the total worth of a company.  

• Signifies the economic value: EV signifies the economic value of the target company.    

• Represents the takeover price: EV represents the theoretical takeover price of the target company and the total cash and debt that the acquiring entity will take.  

• For making comparisons: EV makes it easy to make comparisons of capital structures of companies with different capital structures. EV also assists in valuing capital-intensive businesses.      

• Makes it easier to compare expected returns: EV makes it easier for the stock market investors to compare the expected returns more effectively and neutralise the risk posed by the stock market.  

Conclusion 

To conclude the above mentioned literature, it must be kept in mind that calculating the enterprise value is just as important as finding out the company’s equity capital because it allows the promoters to determine the amount of money they will make after selling it settling its debts. 

Read our Article: Methods of Business Valuation in India