What is enterprise value (EV)
The concept of enterprise value is a widely used term in acquisition transactions. Enterprise value is calculated as full company price (in case of publicly traded companies it is market capitalization) minus excess cash (not necessary for keeping the business going) plus debt.
For example, if the company is currently trading at 52$ per share, there are 1.5M shares outstanding, it makes the market cap of 78M $. This company has 11M $ of cash on its bank account because it earned it in the last year and it was not distributed yet and the company plans no operating investments. Moreover, the company uses debt of 15M $ for its operations.
Enterprise value of this company is calculated as EV = market cap – cash + debt, therefore EV = 78 – 11 + 15 = 82M $.
This may be confusing at the first sight as the company has a higher value, the higher is the debt and the lower value, the higher is the cash sitting on the bank account. Therefore we value the company higher if the company has a bigger debt.
However, it is very important to look at it from the perspective of acquiring entity. It is trying to summarize what it is expected to pay for having the business fully under control. And as the new owner is newly obligated to also pay back the debt, it should be part of the total price.
The logic behind it is, that the excess cash is some form of a discount on the market capitalization, as the money can be withdrawn from the bank account and the debt is something that has to be paid to the debt issuer in order to have a debt-free asset.
If this metric is called total cost of acquisition or something along these lines, it may make more sense. As obviously this is in strict contradiction to the conventional sense of value, this looks definitely more like a measure of price.
Enterprise value is however heavily used by value investors for the sake of market cap adjustments, as the cash sitting on the bank account makes the market price of the company little bit more favourable and the debt makes it a little bit less favourable.
This is definitely an easy and potentially useful way of look at things, but it brings some assumptions which don’t have to necessarily hold for every investor. In the first place, it assumes, that every dollar sitting on the bank account makes the price of the company equally cheaper as the dollar of a market cap decrease. And the same applies to the debt of the company. Every dollar of debt has the same effect on the price of the asset being bought as the dollar of the price increase.
This is very questionable because one doesn’t have to necessarily give credit to allocate the capital being earned the way it is sitting on the bank account. And for the part of adjusting for the debt – taking more and more debt isn’t as easy to conclude as pretending, that the price of the asset has risen.
There is a great podcast on this topic on DIY Investing Podcast.