Enterprise value is a calculation of a company’s total value in dollar terms.
Figuring out what a company is “worth” can be difficult. Often, investors use market capitalization, the dollar value of the company’s outstanding shares, but that number can be misleading.
A better approach is to calculate that first number, the market cap, and then take into account all of the other negatives and positives that would affect the asking price for a company if a theoretical buyer were to make a cash offer.
The is done by adding the value of the company’s stock, both common stock and preferred shares, and then subtracting the company’s debts.
Finally, any cash the company has is added back in, since the new owner would immediately control the cash in the company’s coffers, along with assets such as plants, equipment, inventory and receivables.
Enterprise value is what something is worth. Market cap plus net debt gives a good sense of enterprise value. If a business has a market cap of $1 billion, add the debt of $500 million, then subtract the cash $100 million.
Essentially the business has an enterprise value of $1.4 billion, so I’m paying $1.4 billion for the business.
Put another way, if you have a business that’s $100 a share and it has $10 a share of net cash and no debt, you’re really paying $90 a share.
Enterprise value equalizes things by including how much debt is on the business. Market cap, meanwhile, just tells you the equity valuation.
If it were a house, market cap would tell you how much equity you have, while enterprise value tells you what the house is worth on the market regardless of whether you paid cash or have a big mortgage.
Market cap equals enterprise value if the debt is zero. Some businesses can be highly leveraged. A company could have $100 million in equity value but $900 million in debt.
To do a proper valuation, start with earnings before interest, taxes, depreciation, and amortization (EBITDA) compared to enterprise value. That’s how people looking to buy are really looking at the business.
Net income also has lot to do with how much debt expense a company has. If you compare the price to earnings (PE) ratios two companies but one is heavily indebted, they can’t be compared apples-to-apples.
Warren Buffett, if you read his writings and his talks with business students, really does look at the business itself. He’s looking at the pre-tax earning power of the business when he’s looking at the book value.
Buffett doesn’t talk about enterprise value but instead reads between the lines. What is the pre-tax coupon of the company? What kind of cash can this throw off?
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