Enterprise value and market capitalization (also known as market cap) each measure a company's market value. The two calculations are not identical, and the terms are certainly not interchangeable. However, each offers a peek at a company's overall value and a way to compare similar companies. These numbers are also helpful in determining a fair price to pay for shares of a particular company.
Market Capitalization: A Simplified Valuation Method
Market capitalization is the most simplified way to calculate a company's size, value and, consequently, its growth and risk outlook. This measurement assesses the value of a business based purely on stock. The calculation is a multiple of the stock's current share price and number of shares outstanding.
For example, if XYZ stock is trading at $14 per share and has 2 million shares outstanding, its market capitalization is $28 million. Market capitalization can also give you an idea of the growth and risk to expect from a particular stock. Companies are classified according to market capitalization in many instances. The broad categories are large-, mid- and small-cap. Generally, companies that are considered large cap see slower growth but pose far less risk than small-cap stocks, which often experience accelerated growth, but at the cost of higher risk.
Market capitalization provides an idea of the size of the business and makes it easy to identify peers within a sector. It also demonstrates that share price alone is not a gauge of a company's overall value. Just because a stock has a high share price does not necessarily mean the company is worth more. A great example of this is Ford Motor Company (F), with a seemingly low share price of $13.03 on Jan. 11, 2018. However, Ford is a huge automaker. If you look at its market capitalization, which was about $52 billion, you can also see that the company is worth quite a bit.
Enterprise Value: A More Accurate Valuation
Market capitalization omits important factors in the overall valuation of a company.
For example, if a company were to be purchased, market capitalization would only reflect the cost to acquire the outstanding equity. In reality, the new owner would also become responsible for all outstanding debt.
Enterprise value (EV) calculates a more accurate value of a company, taking into consideration its debt obligations. Though it requires substantially more detailed information than simple market cap, enterprise value gives a much more comprehensive view of a company's worth.
To calculate enterprise value, add market capitalization to the company's outstanding preferred stock and all debt obligations, then subtract cash and cash equivalents.
Enterprise value is very commonly used in value investing to identify undervalued companies. A company with good earnings and possibly even a solid dividend may sound very appealing to many investors. This company might also have a large market capitalization. However, if you look further and calculate the company's enterprise value, you may find serious debt obligations that could pose a problem. If you compare the enterprise value of an equally well-earning company and find it has a higher enterprise value, purchasing the latter stock would be a better overall value.