What is Enterprise Value (EV)?

Enterprise value (EV) is a measure of a company's total value, often used as a more comprehensive alternative to equity market capitalization. EV includes in its calculation the market capitalization of a company but also short-term and long-term debt as well as any cash on the company's balance sheet. Enterprise value is a popular metric used to value a company for a potential takeover.

Formula and Calculation for EV

Source: eduCBA

EV=MC+Total Debt−C

where:
MC=Market capitalization; equal to the current stockprice multiplied by the number of outstanding stock shares
Total debt=Equal to the sum of short-term andlong-term debt
C=Cash and cash equivalents; the liquid assets ofa company, but may not include marketable securities

To calculate the market capitalization if not readily available you would multiply the number of outstanding shares by the current stock price. Next, total all debt on the company's balance sheet including both short-term and long-term debt. Finally, add the market capitalization to the total debt and subtract any cash and cash equivalents from the result.

What Does Enterprise Value Tell You?

Enterprise value (EV) could be thought of like the theoretical takeover priceif a company were to be bought. EV differs significantly from simple market capitalizationin 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. As a result, 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 reserveson the other. Enterprise value is basically a modification of market cap, as it incorporates debt and cash for determining a company's valuation.

Market capitalization is not intended to represent a company's book value. Instead, it represent's a company's value as determined by market participants.

Limitations of Using EV

As stated earlier, EV includes total debt, but it's important to consider how the debt is being utilized by the company's management. For example, capital intensive industries such as the oil and gas industry typically carry significant amounts of debt, which is used to foster growth. The debt could be used to purchase plant and equipment. As a result, the EV would be skewed for companies with a large amount of debt as compared to industries with little or no debt.

As with any financial metric, it's best to compare companies within the same industry to get a better sense of how the company is valued relative to its peers.