The enterprise value (EV) is an indicator of how the market attributes value to a firm as a whole. Enterprise value is a term coined by analysts to discuss the aggregate value of a company as an enterprise rather than just focusing on its current market capitalization.

The market cap figure measures how much you need to fork out to buy an entire public company. When sizing up a company, investors get a better picture of the real value with enterprise value, compared to market cap.

Why doesn't the market cap properly represent a firm's value? First, it leaves a lot of important factors out, such as a company's debt and its cash reserves. Enterprise value is basically a modification of market cap, as it incorporates debt and cash for determining a company's valuation.

Enterprise Value Calculation

Simply put, EV is the sum of a company's market cap and its net debt. To compute the EV, total debt—both short- and long-term—is added to a company's market cap, then cash and cash equivalents are subtracted.

Market capitalization is the share price multiplied by the number of outstanding shares. So, if a company has 10 million shares, each currently selling for $25, the market capitalization is $250 million. This number tells you what you would have to pay to buy every share of the company. Therefore, rather than telling you the company's value, market cap simply represents the company's price tag.

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The Difference Between Enterprise Value and Equity Value

The Role of Debt and Cash

Why are debt and cash considered when valuing a firm? If the firm is sold to a new owner, the buyer has to pay the equity value (in acquisitions, the price is typically set higher than the market price) and must also repay the firm's debts. Of course, the buyer gets to keep the cash available with the firm, which is why cash needs to be deducted.

Think of two companies that have equal market caps. One has no debt on its balance sheet, while the other one is heavily indebted. The debt-laden company will be making interest payments on the debt over the years. So, even though the two companies have equal market caps, it would cost more to purchase the company with more debt.

By the same token, imagine two companies with equal market caps of $250 million and no debt. One has negligible cash and cash equivalents and the other has $250 million in cash. The first company would have an enterprise value of $250 million, while the second company's EV would be $500 million.

If a company with a market cap of $250 million carries $150 million as long-term debt, an acquirer would ultimately pay a lot more than $250 million to buy the company in its entirety. With the $150 million in debt, the total acquisition price would be $400 million. Although debt increases the purchase price, cash decreases the price.

Enterprise Value Ratios

Frankly, knowing a company's EV alone is not all that useful. You can learn more about a company by comparing EV to a measure of the company's cash flow or earnings before interest and taxes (EBIT). Comparative ratios are ideal for assessing companies with different capital structures.

EBIT is key for comparative ratios given the fact that enterprise value assumes the acquirer immediately pays debt and consumes cash, thus, not accounting for interest costs or interest income. An even better metric is free cash flow, which helps avoid other accounting distortions.

For example, let's look at the price of two comparable stocks: Air Macklon and Cramer Airlines. At $45 per share, Macklon had a market cap of $13.5 billion and price-to-earnings (P/E) ratio of 10. But its balance sheet was burdened with nearly $30 billion in net debt. So Macklon's EV was $43.5 billion, or nearly 13 times its $3.4 billion in EBIT.

By contrast, Air Cramer enjoyed a share price of $23 per share and a market cap of $6.1 billion, with a P/E ratio of 20—twice that of Air Macklon. But because Cramer had a much lower net debt, coming in at $3.5 billion, its EV was $9.6 billion and its EV/EBIT ratio was only 10.

By market cap (P/E) alone, Air Macklon looked like it was half the price of Cramer Airlines. But on the basis of EV, which takes into account important things like debt and cash levels, Cramer Airlines was priced much less per share. As the market gradually discovered, Cramer represented a better buy, offering more value for its price.

The Bottom Line

The value of EV lies in its ability to compare companies with different capital structures. By using enterprise value instead of market capitalization to look at the value of a company, investors get a more accurate sense of whether or not a company is truly undervalued.