Enterprise value

In simple terms

Market capitalisation is the value of a company's shares. But a company is funded by lenders as well as shareholders. If you bought every share, you would also take on the company's debts, and you would get its cash.

Enterprise value (EV) estimates the value of the whole operating business, owed to everyone who funded it:

A worked example

Further adjustments

To be complete, EV includes every claim on the operating business and excludes assets that are not part of it.

Add:

• Minority interests (non-controlling interests): when a company consolidates a subsidiary it does not fully own, the subsidiary's whole profit is included in the consolidated figures, so the value belonging to the other shareholders must be added. The operating and net profit lesson explains non-controlling interests.
• Preference shares, which rank ahead of ordinary shareholders.
• Debt-like items such as lease liabilities, unfunded pensions and deferred payments for acquisitions, as discussed in the debt lesson.

Subtract:

• Cash and liquid investments not needed to run the business.
• Investments in associates and other non-core holdings, valued separately, whose profits are not included in the operating figures you are comparing with.

Be consistent: if you subtract an investment from EV, make sure its income is not in the profit you divide EV by.

Why EV compares companies fairly

Market capitalisation is distorted by financing. Two businesses with identical operations can have very different market capitalisations if one is funded with debt and the other with equity. EV is much less affected, because it adds the debt back.

This is why EV is paired with measures of profit before interest, such as EBITDA and EBIT, which belong to both lenders and shareholders. The EV/EBITDA lesson builds on this.

Why it matters

EV answers a practical question, what the whole business costs, and it stops a heavily indebted company from looking cheap just because its shares are cheap. It is also the starting point for many valuation methods, including discounted cash flow, where the value of the business is calculated first and then debt is subtracted to reach the value of the shares.

Limitations

EV uses the balance sheet's debt and cash at one date, which may differ from the average. Debt is usually taken at book value rather than market value. Deciding which cash is surplus, and which items count as debt-like, needs judgement. For banks and other lenders, whose debt is their raw material, EV is not a meaningful measure.

Common mistakes

• Treating market capitalisation as the cost of the company.
• Forgetting leases, minority interests or preference capital.
• Dividing EV by net profit, which is after interest and belongs only to shareholders.
• Using EV for banks and lenders.

Try it yourself

1. Choose a listed company with significant borrowings.
2. Calculate its market capitalisation from the share price and share count.
3. From the balance sheet, add borrowings, lease liabilities and non-controlling interests, and subtract cash and liquid investments.
4. Compare its enterprise value with its market capitalisation, and repeat for a debt-free competitor.