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The Enterprise Value Formula and What It Tells You

The enterprise value (EV) is the best metric if you want to gauge the real value of a company. Unlike market cap, which is the value of the company based on the shares outstanding, the enterprise value takes into account the market cap., the market value of debt, minority interests, preferred shares (if any), and the cash available. Therefore, it is more accurate.

corporation building to represent enterprise value

Breaking Down the Enterprise Value Formula

The enterprise value formula consists of five separate components:

  • Market cap. (Equity value): the value of the company based on its current stock price and the number of shares outstanding. To be accurate, you need to take the average number of shares outstanding, i.e. the shares at the beginning of the year and the shares at the end of the year and divided them by 2.
  • Market value of debt: this is the hardest component to obtain from a company’s balance sheet because most companies have bank debt, which pertains to their book value and not to their market value. Therefore, you need to calculate the market value of debt using the formula below:

Market value of debt = E ((1-(1/ (1 + R) ^Y))/R) + T/ (1 + R) ^Y

Where:

  • E = annual interest expense (it is on the income statement)
  • R = cost of debt (total interest / total debt)
  • T = total debt
  • Y = average maturity of debt (in years)

 

  • Minority interest: it represents the interest of minority shareholders in the parent company’s net assets and it can be found on the income statement.
  • Preferred shares: they represent an ownership with a higher claim on the company’s assets and earnings than the common shares. Preferred shares, if they exist, are declared on the company’s balance sheet
  • Cash and cash equivalents: on the balance sheet

Therefore, the enterprise value formula is:

EV = market capitalization + market value of debt + minority interest + preferred shares – cash and cash equivalents

Why Enterprise Value Is Important

Let’s say that you are holding Johnson & Johnson (NYSE: JNJ), Procter & Gamble (NYSE: PG), Amgen (NASDAQ: AMGN), and Sanofi (NYSE: SNY) stocks in your portfolio. Since it is not possible to know the average maturity of debt, we assume an average maturity of 5 years for the sake of calculations. So, the cost of debt for each company (total interest / total debt) is:

cost of debt example

Now we can apply the cost of debt to the formula, to find the market value of debt:

Market value of debt = E ((1-(1/ (1 + R) ^Y))/R) + T/ (1 + R) ^Y

  • JNJ: 552 x ((1-(1/1+2.05%)^5))/2.05% + 26,989/ (1+2.05%)^5 = 21,515
  • PG: 579 x ((1-(1/1+1.86%)^5))/1.86% + 31,125/ (1+1.86%)^5 = 25,380
  • AMGN: 1,095 x ((1-(1/1+3.10%)^5))/3.10% + 35,323/ (1+3.10%)^5 = 24,497
  • SNY: 607 x ((1-(1/1+3.50%)^5))/3.50% + 17,336/ (1+3.50%)^5 = 11,340

Now, we can calculate the enterprise value of each company:

enterprise value formula example

Notice that, in all four stocks, the enterprise value is higher than the market cap. as it considers the company’s total debt and cash. Many investors look at the company’s market cap or P/E ratio to determine whether the company is a strong asset in their portfolio. However, the enterprise value tells you the real value of the business.  Also, some analysts are using the book value of debt (short-term debt + long-term debt) instead of calculating the market value of debt because they do not know the years to maturity (Y). Finally, if you change the years to maturity, for instance from 5 to 10, you will get a lower enterprise value because the market value of debt will be lower.

The EV /EBITDA Multiple

The EV/EBITDA multiple is widely used, especially in industries that require a substantial investment, such as the pharmaceutical industry. Also, it is an important metric in leveraged buyouts, where analysts are looking for the cash that a firm generates free of expenses.

The next step is to determine the EBITDA for each company as follows:

ebitda calculation

Therefore, the EV/EBITDA for each company is:

ev ebitda calculation

Usually, an EV/EBITDA less than 10.0 is considered as healthy, but the relative comparison between similar firms in the industry is necessary. Notice how the EV/EBITDA multiples compare to each other. Procter & Gamble has the highest EV/EBITDA ratio because it has the highest market value of debt. Sanofi has the lowest EV/EBITDA multiple because it has the lowest EBITDA and the lowest market value of debt. If there is one thing you can be sure about in Finance is the inverse or direct correlation of numbers to each other.

Summarizing, the enterprise value formula attempts to determine the value that it would cost an acquirer to take over the target company, and it considers a firm’s capital structure, i.e. both debt and equity. EBITDA ignores a company’s capital structure, and it reflects the cash that a firm can generate before interest, taxes, depreciation, and amortization expenses. That means it doesn’t discriminate between equity holders or debt holders, but it accounts for the entire firm. Finally, in leveraged buyouts, a low EV/EBITDA is preferred because it indicates that the target company is an attractive takeover.