What is Enterprise Value (EV)?
Enterprise Value (EV) is a direct valuation metric, used to measure a company’s total value; that is, an estimated cost of acquisition. It is treated as a more comprehensive alternative to equity Market Capitalization. In this blog post, we will learn what is Enterprise Value , how to calculate it, why among all comparative ratios EV-to-EBITDA is the best ratio, and few more important ratios.
The Market Capitalization (Market Cap) is one of the most fundamental parameters to value any company. But if a company has huge debt then the investors avoid relying only on Market Cap. That’s when the EV metric is useful. Remember the recent Air India takeover case, where bidding was done at EV?
Use of EV is popular in such cases as it considers Market Cap of company, along with net debt (short-term and long-term debt minus liquid cash). EV as compared to Market Cap, evaluates the company’s strong and weak points and hence, it more accurately determines at what levels the stock is likely to be a good buy.
How to calculate EV (formula):
Enterprise Value (EV) = Market Capitalization + Debt – Cash
For example,
Market Cap of ABC & Co. is Rs 15,00,00,000,
Debt is Rs 1,43,00,000 and Cash and cash equivalents is Rs 98,00,000, Hence,
EV = Rs 15,00,00,000 + Rs 1,43,00,000 – Rs 98,00,000
EV = Rs 15,45,00,000
Thus, if a company has debt higher than cash & cash equivalent, then the Enterprise Value is always expected to be greater than Market Capitalization. However, in the case if the net cash position is higher (debt lower than cash & cash equivalent), then the Market Cap will be higher than EV.
This calculation makes sense in terms of the fact that when an investor plans to buy a company, he must pay for its debt as well as its assets and earnings potential. Financially sound companies will certainly have enough net cash to avoid bankruptcy, while it’s not practical to have low or no debt. When a company has debt that is zero (or close to zero) and a steady stream of revenue, this can result in negative EV.
Using EV method makes it easy for investors to compare companies having different capital structures. It also helps determine if the company is undervalued by calculating its accurate value.
PE vs EV-to-EBITDA:
Although Price to Earnings ratio is a benchmark for equity valuation, it’s major drawback is that it does not consider debt, which also is part and parcel of capital. That’s where EV-to-EBITDA (EBITDA is Earnings Before Interest, Taxes, Depreciation, and Amortization) ratio comes into play. EV-to-EBITDA gives a more realistic output as it values the worth of the entire company.
EV-to-EBITDA ratio:
The EV-to-EBITDA ratio is calculated by dividing EV by EBITDA. The ideal output of this metric varies from industry to industry. Typically, EV-to-EBITDA value which is below 10, is considered to be safe.
Thus, advantage of the EV-to-EBITDA ratio is that it does not consider debt costs, taxes, depreciation, and amortization. So it offers a more precise picture of the company’s financial performance.
What does EV-to-EBITDA output value indicate?
EV-to-EBITDA output value indicates the payback period of an investment in the company. For example, when the EV-to-EBITDA is say 6, it means that it will take approximately 6 years for the investment to recover the cost of acquiring that company through EBITDA.
Do catch up with us through our following blog post, where we’ll learn about comparative ratios with EV and understand their importance.
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