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What is the 'Enterprise Value (EV)'

The Enterprise Value, or EV for short, is a measure of a company's total value, often used as a more comprehensive alternative to equity market capitalization. Enterprise value is calculated as the market capitalization plus debt, minority interest and preferred shares, minus total cash and cash equivalents.

EV = market value of common stock + market value of preferred equity + market value of debt + minority interest - cash and investments.

Often times, the minority interest and preferred equity is effectively zero, although this need not be the case.

BREAKING DOWN 'Enterprise Value (EV)'

Enterprise value (EV) can be thought of as the theoretical takeover price if a company were to be bought. EV differs significantly from simple market capitalization in several ways, and many consider it to be a more accurate representation of a firm's value. The value of a firm's debt, for example, would need to be paid off by the buyer when taking over a company, thus, enterprise value provides a much more accurate takeover valuation because it includes debt in its value calculation.

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

Enterprise Value in Practice

The formula for EV is essentially the sum of a the market value of equity (market capitalization) and the market value of debt of a company, less any cash. The market capitalization of a company is calculated by multiplying the share price by the number of shares outstanding. The net debt is the market value of debt minus cash. A company acquiring another company gets to keep the cash of the target firm, which is why cash needs to be deducted from the firm's price as represented by market cap.

Let's calculate the enterprise value for Macy's (NYSE:M). For the fiscal year ended January 28, 2017, Macy's recorded:

Macy's Data Pulled from 2017 10-K Statement
1 # Outstanding Shares 308.5 million  
2 Share Price as of 11/17/17 $20.22  
3 Market Capitalization $6.238 billion Item 1 x 2
4 Short-Term Debt $309 million  
5 Long-Term Debt  $6.56 billion  
6 Total Debt $6.87 billion Item 4+ 5
7 Cash and Cash Equivalents $1.3 billion  
  Enterprise Value $11.808 billion Item 3 + 6 - 7

If a company were to purchase Macy's outstanding shares for $6.24 billion, it will also have to settle Macy's outstanding debts which sum up to $6.87 billion. In total, the acquiring company will spend $13.11 billion to purchase Macy's. However, since Macy's has $1.3 billion in cash, this amount can be added to repay the debt. The money from the coffers of the acquiring company that will be used to pay off Macy's debt will only be $6.87 billion - $1.3 billion = $5.57 billion. Therefore, the company will pay, out-of-pocket, $5.57 billion + $6.24 billion = $11.81 billion, which is the estimated market value of Macy's.

Enterprise Value as an Enterprise Multiple

Enterprise multiples that contain enterprise value relate the total value of a company as reflected in the market value of its capital from all sources to a measure of operating earnings generated, such as earnings before interest, taxes, depreciation and amortization (EBITDA).

EBITDA = recurring earnings from continuing operations + interest + taxes + depreciation + amortization

The Enterprise Value/EBITDA multiple is positively related to the growth rate in free cash flow to the firm (FCFF) and negatively related to the firm's overall risk level and weighted average cost of capital (WACC).

EV/EBITDA is useful in a number of situations:

  • The ratio may be more useful than the P/E ratio when comparing firms with different degrees of financial leverage (DFL).
  • EBITDA is useful for valuing capital-intensive businesses with high levels of depreciation and amortization.
  • EBITDA is usually positive even when earnings per share (EPS) is not.

EV/EBITDA also has a number of drawbacks, however:

  • If working capital is growing, EBITDA will overstate cash flows from operations (CFO or OCF). Further, this measure ignores how different revenue recognition policies can affect a company's OCF.
  • Because free cash flow to the firm captures the amount of capital expenditures (CapEx), it is more strongly linked with valuation theory than EBITDA. EBITDA will be a generally adequate measure if capital expenses equal depreciation expenses.

Another commonly used multiple for determining the relative value of firms is the enterprise value to sales ratio, or EV/Sales.  EV/sales is regarded as a more accurate measure than the Price/Sales ratio since it takes into account the value and amount of debt a company has, which needs to be paid back at some point. Generally the lower the EV/sales multiple the more attractive or undervalued the company is believed to be. The EV/sales ratio can actually be negative at times when the cash held by a company is more than the market capitalization and debt value, implying that the company can essentially be by itself with its own cash.

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