What aspects do you look into before investing in a company’s shares?
Analysing a company’s financial value is one of the significant factors in decision making along with other factors like the current market price of shares, market trends, etc.
Various technical and fundamental indicators help in analysing the elements of investing.
Enterprise value is a tool under fundamental analysis used to understand the financial aspects of a business.
Enterprise value – meaning
Enterprise value is a valuation tool that helps determine a company’s worth. There are multiple ways of valuing a company – market capitalisation, book value, discounted cash flow method, etc.
While each of them analyses a company’s value through different perspectives, enterprise value determines its worth based on its purchase price.
If you had to purchase an existing company today, how much would you shell out for it? Enterprise value answers this for you.
EV is one of the most used tools in determining company valuations during mergers and acquisitions.
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Factors involved in determining enterprise value
- Market capitalisation – The total value shares outstanding i.e., the total value of a company’s shares held by all the shareholders.
Formula: Number of outstanding shares * Prevailing market price per share - Total debt – The total debt considers the sum of all the debts – short-term, long-term, secured, unsecured, and any other outstanding amount to be paid by the company.
- Cash and cash equivalents – This component calculates the total cash in the company along with the value of highly liquid assets such as treasury bills and commercial papers.
Marketable securities (stocks) are not included as they are already a part of market capitalisation.
How is enterprise value calculated?
Enterprise value formula= Market capitalisation + Total debt – Cash and cash equivalents
The market capitalisation of companies is generally available on various websites. If not, it can be calculated based on the number of outstanding shares and the current market price per share.
The total debt and cash components are available on the balance sheet of companies.
What does it indicate?
The enterprise value determines the amount necessary to purchase a company.
Market capitalisation is the base value which is the major component of the enterprise value.
While taking over a company, the existing liabilities are acquired too. So, the cost of such liabilities comes under total debt and forms a part of the acquisition cost.
Cash and cash equivalents are deducted as this is the benefit or reduction in price that the buyer gets. The buyer acquires the business along with its liquid assets. It brings down the actual cost of acquisition, hence the deduction.
A negative EV suggests that the company may have excessive cash which is not being utilised to run the business effectively.
It may also indicate that the current market price of the company’s share is low.
EV is more accurate than the market capitalisation method while determining a company’s worth, as it takes multiple factors into consideration.
Also Read: What is gross profit? What does it indicate about a company’s financial position?
Enterprise value with other ratios
Enterprise value is used as a base value while calculating other ratios.
- EV and EBITDA
EBIDTA = Earnings Before Interest Tax Depreciation and Amortisation.
EV/EBITDA is an effective tool for comparing a company’s worth against its earning potential.
This is ideal for investors looking to compare different businesses belonging to the same sector.
- EV and sales
Price/Sales is a popular tool used to assess a company’s value.
While price uses the market capitalisation value, EV/Sales uses the enterprise value.
Since EV factors in the debt component as well, it is considered more suitable.
A low EV/Sales ratio suggests that the earning capacity of the firm is high. Hence, the lower the EV/Sales, the better it is.
Enterprise value against other ratios
- Enterprise value vs. market capitalisation
Enterprise value is an improvement to the market capitalisation method of valuing firms.
While market capitalisation considers a single factor, EV uses multiple factors to arrive at a company’s valuation.
Consider an example of two companies having the same share price in the market with an equal number of shares outstanding. Both companies will have equal value as per the market capitalisation method.
Let us now assume that one of them has a debt. The debt gets ignored, and both companies are valued equally.
The valuation is inaccurate because the company without any debt is undoubtedly more valuable than the company with debt.
Such inaccuracies get captured under enterprise value.
- Enterprise value vs. P/E ratio
As discussed so far, EV is more comprehensive. The Price-to-earnings (P/E) ratio focuses only on the share price and earnings per share.
The EV method offers more precision for capital-intensive businesses, where debt is a significant component.
Limitations
- The utility of debt is a significant factor in analysing a company’s value. Companies using debt to finance their capital and grow in revenue are better than those using debt to pay off expenses like salaries and rent. Enterprise value does not include this factor.
- In cases where the debt in the balance sheet is manipulated, enterprise value does not help in valuing a company accurately.
- Other costs associated with purchasing a company, like the legal fees, premiums, etc., are not part of enterprise value. Hence, EV does not represent the real cost of acquiring a business.
Example
| Particulars | Amount in ₹ |
| Shares outstanding | 1,00,000 |
| Current market price | ₹ 100 |
| Short term debt | 0 |
| Long term debt | ₹ 5,00,000.00 |
| Cash | ₹ 2,00,000.00 |
| Commercial papers and treasury bills | ₹ 1,75,000.00 |
Market capitalisation = Shares outstanding * Current market price- 1,00,000 * 100 = ₹ 1,00,00,000
Enterprise value = Market capitalisation + debts - cash and cash equivalents- ₹ 1,00,00,000 + 5,00,000 – 3,75,000 = ₹ 1,01,25,000
Below is a table representing the enterprise value of Reliance Industries for the last 5 years:
| Enterprise value (In crores) | 2023 | 2022 | 2021 | 2020 | 2019 |
| 1,736,200.43 | 1,954,716.18 | 1,479,239.4 | 950,998.06 | 1,017,464.40 |
Bottomline
While enterprise value method seems holistic since it considers multiple components for company valuations, it has certain limitations, too.
EV is a good indicator, but EV/EBITDA is considered a better indicator to assess a company’s worth. The lower the EV/EBITDA, the higher the company’s value.
So, EV is a better tool when used in combination with other financially significant factors like the EBITDA, P/E Ratio, etc.
