Enterprise value (EV) and market capitalization (or market cap) are important metrics to analyze the value of a company. The market cap figure offers valuable information about the equity value of the firm.
Contrarily, the EV calculations consider the equity value, debt incurred, and cash held by a company. Thus, it offers a comprehensive analysis of the total capital valuation of a company.
Let us discuss the calculation methods of EV and market capitalization and see how useful are these terms.
What is the Enterprise Value of a Company?
Enterprise value is the theoretical total value of a company. It includes the equity market value plus debt and it also considers the cash and cash equivalents in the equation.
The enterprise value (EV) represents a useful alternative measure to equity market capitalization. It is a closer figure of the takeover value of a company considering its current market value.
The EV of a company considers all practical implications of analyzing the true market value of the firm. For instance, when the market value of a firm is analyzed, it also considers debt, assets owned, and the cash balance of the firm.
How to Calculate the Enterprise Value of a Company?
Let us first look at the formula to calculate the EV of a company.
Enterprise Value = Market Capitalization + Total Debt – Cash
Market Capitalization = Total Shares Outstanding × Current Share Price
The total debt figure includes both short-term and long-term debts of a company. It is added to the market cap figure. For precision, the total debt figure can also include preference shares and other minority interests held by the company.
The purpose is to include all types of debt that a potential acquirer would have to settle theoretically.
The cash balance will include cash, cash equivalents, marketable securities, and other liquid assets held by the company.
Note: Some calculations consider only the cash and cash equivalents and exclude other liquid assets such as bank drafts, marketable securities, etc.
Importance and Interpretation of the Enterprise Value
The enterprise value of a company can be used as a theoretical total value of the company. We can analyze each component of the calculation for comprehensive analysis.
The first component is the market capitalization of the company. It considers the market value of the equity side. The current share price also reflects the effects of assets, cash, and liabilities held by the company.
For increased accuracy, the EV equation adds the debt value to the market cap figure. The purpose is to collect a realistic value of the company that a potential acquirer would pay.
Next, the EV figure excludes the cash and cash equivalent from the equation. Again, it gives a realistic approach since the new acquirer would own the cash balances held by the company.
The enterprise value is used in several types of market valuation and accounting analysis as well.
For example, the EV figure is used as an alternative to the commonly used P/E multiple. The P/E figure does not consider the debt value of a company. Thus, the EV would be a better multiplier for the valuation analysis.
Similarly, we can use EV/EBDITA and EV/EBIT are useful measures to analyze the company’s enterprise value (net resources held) against the earnings.
The EBDITA figure does not exclude non-cash items from the analysis. Therefore, many analysts use EBIT as an alternative measure.
Both of these figures are used to compare the market enterprise value of the company against its earnings, debt incurred, and cash resources.
Similarly, we can use EV/Sales as an alternative measure to the common income statement analysis metrics.
What is the Market Capitalization of a Company?
Market capitalization or simply the market cap is the market value of the equity of a company.
Market cap is the total shares outstanding for a company multiplied by its current share price. It means the resulting figure gives the market value of the equity side of the company.
Market cap is a useful metric that provides the market value of a company in terms of the current share price. Analysts argue that the current share price of the company absorbs all effects of assets, debt incurred, and liabilities of a company.
Market cap largely depends on the share price movements. Even after the IPO of a company, its share prices would adjust once the market absorbs the IPO impact.
The other component is the total shares figure that changes less frequently. Outstanding shares change with significant events such as new shares issue, share repurchase, management buyouts, and employee share compensation schemes.
How to Calculate the Market Capitalization of a Company?
The formula to calculate the market capitalization of the company is:
Market Capitalization = Total Shares Outstanding × Current Share Price
There are only two components to calculate the market capitalization. Both of these items are readily available for any publicly listed company.
The total outstanding shares include common stocks of all classes such as Class A, Class B shares. The current share price is the trading price of the shares of that company.
Importance and Interpretation of Market Capitalization
Market cap is a quick and easy method to calculate the market value of a company. Although it considers only the equity value of the company.
Market capitalization can be used as a starting figure to evaluate the total value of a firm. It can also be used to categorize companies based on their total market cap.
For investors, the market cap of a company can offer several useful investment indicators. For example, large-cap companies are financially strong and often come with an established working history.
Similarly, mid or small-cap firms are more volatile than large-cap companies. However, these companies demonstrate faster growth rates as compared to large-cap companies.
Since the market cap largely depends on the current share price, it will change frequently. Also, it does not represent the total equity of a company as well. Share prices are often triggered by the demand-supply rule, thus, they do not represent the actual equity value of the company.
Working Example
Let us consider a real-world example to calculate the Market Capitalization and the Enterprise Value (EV) of Facebook Inc.
Market Capitalization
Total Outstanding Shares = 2,843,000 million (including Class A and Class B Common Stocks)
Current Share Price = $ 341.88
Market Capitalization = Total Outstanding Shares × current share price
Market Capitalization = $ 971.96 billion
The figures are calculated using the current market share price available and the total outstanding shares as per the 10-K form for the year ended 2020.
Enterprise Value
Now let us calculate the EV of Facebook using the available data from the same 10-K form.
The formula to calculate the EV is:
EV = Market Cap + Debt – Cash
Debt = Short-Term Debt + Long-Term Debt
Debt = 1,023 + 9,631 = $ 10,654 million
Cash = Cash + Marketable Securities
Cash = 17,576 + 44,378 = $ 61,954 million
We have a market cap figure of $ 971.96 billion as calculated above.
We can now calculate the EV of Facebook using these inputs.
EV = $ 971,960 + $ 10,654 – $ 61,954
EV = $ 920,660 million or 920.66 billion
Enterprise Value Vs Market Capitalization
As we can see, both of these measures can be used for similar analysis but with different approaches.
Market cap uses the current share price to calculate the equity value of the firm. Although it does not fully cover the total equity of a company, it is a useful and realistic approach.
The market cap can be taken as a starting point to evaluate the total market value of a company. Investors can use it to categorize and evaluate different companies based on their capitalization size.
The enterprise value of the firm closely reflects the total value of a company. It includes market capitalization as a component. It also adds the total debt of the company for valuation purposes. The aim is to reach a realistic value that an acquirer would willingly pay for a company.
Enterprise value also excludes cash reserves held by a company. Again, the purpose is to reach a realistic market value of the firm.
Although EV is a better measure as compared to the market cap it comes with some limitations as well. EV ignores the fact that some companies would inevitably be highly leveraged. The utilization of debt is an important aspect when considering the debt owed by a company.
Hence, as with any other financial performance evaluation metric, the EV of similar companies and within the same industry should be analyzed.
Concluding Remarks
The market cap figure can be used to analyze the growth prospects, investment potential, and equity valuation of a firm. The figure considers the market value of the equity. Thus, it is more useful for equity investors than analysis for the total valuation of the firm.
On the other hand, EV includes the market cap figure as well. It means the EV figure can be used for the total market valuation analysis realistically. However, both the market cap and EV require some adjustments.
