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Enterprise Value (EV) represents the total value of a company, encompassing its market capitalization, cash or cash equivalents on the balance sheet, and both short-term and long-term debts. It is often used as an alternative to equity market capitalization and plays a significant role in discussions regarding mergers and acquisitions, aiding in determining the value of the companies involved.
EV is a calculation that theoretically represents the overall cost of acquiring an entire company if it were to be taken over by a single entity. In the case of a publicly traded company, this would entail purchasing all shares, resulting in the company transitioning into private ownership. EV provides a more precise estimation of acquisition expenses compared to market capitalization, as it considers various other crucial elements such as preferred stocks, debts (including bank loans and corporate bonds), and excess cash.
Essentially, Enterprise Value is a
modified version of market capitalization, as it incorporates debt and cash to ascertain the true value of the company.
The calculation for market capitalization involves multiplying the current stock price by the total outstanding shares, a figure commonly provided in the company's financial reports. Upon totaling all debts listed in the company's balance sheet, including short-term and long-term liabilities, the values of market capitalization and total debt are aggregated. Subsequently, all liquid assets are deducted.
Enterprise Value (EV) = Market Capitalization + Total Debt – Cash and Equivalents
In simpler terms, Enterprise Value indicates the expense linked to acquiring each common and preferred share of a company, alongside its outstanding debts. Deducting cash reserves is essential because, upon full acquisition, the cash becomes part of the ownership.
Market Capitalization
Market capitalization is determined by multiplying the number of outstanding shares by the current price per share. For instance, if a company has 1 million outstanding shares and the current share price is CHF 20 per share, the company's market capitalization would be CHF 20 million.
Debt
The value of a company extends beyond its common stock alone. For instance, if a company carries debts resulting from investments in machinery and infrastructure improvements, these obligations become part of the acquisition. When acquiring a company, the acquirer usually takes responsibility for the debts held by that company.
Cash (and Cash Equivalents)
Upon purchasing a company, the buyer gains ownership of all cash reserves held by the acquired company. These reserves contribute to reducing the acquisition cost. Therefore, when calculating enterprise value, subtracting cash and cash equivalents from the other components is important.
Preferred Stock
Although technically part of equity, preferred stocks can function either as equity or debt. A preferred stock that must be repurchased at a certain price at a specified time is, in all respects, a form of debt. In other cases, preferred shareholders may hold rights to fixed dividends and participate in profits. Convertible preferred stocks can be exchanged for common stocks. Nevertheless, preferred stocks represent a claim on the company and need to be considered in the enterprise value calculation.
Enterprise Value serves as a tool to assess the worth of an investment in a company relative to its competitors.
Certain investors, especially those who follow a value investing philosophy, look for companies that generate a substantial cash flow in relation to their enterprise value. Firms within this category are more inclined to necessitate minimal additional reinvestment.
However, relying solely on Enterprise Value as the sole method for evaluating a company also presents drawbacks. For instance, high levels of debt can potentially diminish a company's perceived value, even if the debts are adequately employed.
Companies with substantial equipment needs often hold considerable debt levels, a characteristic shared by their industry counterparts. Thus, it's important to solely use enterprise values for comparisons within the same industry.
Enterprise Value (EV) is a frequently used part of financial metrics to measure a company's performance. Financial metrics aim to gauge a company's performance, often by relating profits or a portion thereof to the enterprise value. The measure of profit can vary, such as earnings before interest, taxes, depreciation, and amortization (EBITDA).
EV/EBITDA
The EV/EBITDA ratio is employed to compare a company's value, including its debts, with the cash earnings of the company, minus non-cash expenses. It is particularly useful for analysts and investors seeking to compare companies within the same industry.
Advantages:
- This ratio can be more useful than the price-to-earnings ratio (P/E ratio) when comparing companies with differing debt levels.
- It is beneficial for assessing capital-intensive companies with high depreciation and amortization, as these are excluded from the ratio.
- EBITDA typically remains positive even if earnings per share (EPS) are negative.
Disadvantages:
- As the operating working capital grows, EBITDA may overestimate operating cash flow (OCF). Additionally, it does not consider how different revenue recognition strategies can affect a company's OCF.
- Since the company's free cash flow captures the amount of capital expenditures (CapEx), it is more closely linked to valuation theory than EBITDA. EBITDA is generally an appropriate measure when capital expenditures are equal to depreciation expenses.
EV/Sales
Another commonly used multiplier is EV/Sales. EV/Sales is deemed a more precise metric than the price-to-sales ratio as it accounts for a company's value and the magnitude of debts that must be repaid eventually. A low EV/Sales ratio suggests an undervalued company. The EV/Sales ratio becomes negative when a company's cash surpasses its market capitalization and debt value.
The Price-to-Earnings Ratio (P/E Ratio) compares the current stock price to the earnings per share (EPS). The P/E ratio is also known as a price multiplier or earnings multiplier. Unlike EV, the P/E ratio does not consider the level of debts listed on a company's balance sheet. Generally, it is worthwhile to calculate both metrics.
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