What is the value of a company? Strictly speaking, company value is equal to equity on the balance sheet (aka book equity value). After all, equity is equal to total assets minus total liabilities, and it makes sense that a company worth its net assets — right? Not exactly. Net asset value ignores several key concepts such as debt holdings and future earning potential. That’s where enterprise value comes into play.
In short, enterprise value considers that a company’s worth comes from equity and debt holders alike, so its value is equal to (1) market value of equity + (2) total debt – (3) cash. Debtors “own” a stake in a company because they have a right to be paid, and cash is subtracted because it can, at any time, be used to pay down debt. Another way to think of it is the value of a home. You don’t tell someone that your house is worth $100k because you have a $100k mortgage. You tell them your home is worth $200k — it’s intrinsic value.
Note that [total debt] – [cash] is also known as net debt. You will hear this term often, so it’s worth remembering.
This article discusses mainly (1) what enterprise is used for and (2) why it’s so important. We’ll talk about what makes it different from other valuation computations such as equity value, as well as how to calculate it. In addition, we’ll cover what a negative EV means and how to assess financial ratios that use EV.
What is enterprise value used for?
Succinctly, enterprise value is used for company valuations in the context of M&A, stock investing, stock option evaluation, leveraged buyouts (LBOs), financial analysis, and nearly all other valuation scenarios. It represents a standard financial metric including debt and equity that applies to private and public companies alike, which provides like-for-like comparisons to financial decision-makers.
Why is enterprise value important?
Enterprise value is critical in finance. In short, EV’s sum of equity and debt stakeholders shows the full picture of a company’s ownership and prevents it from “hiding” debt obligations from investors, which is the core fault in equity value. Moreover, EV standardizes company valuations by implementing a simple purchase-scenario logic: if you want to buy a company, you need to pay its shareholders and creditors the money they’re due, which is the enterprise value.
Note, however, that while buyers do not always need to pay down debt as part of a transaction, EV creates a common metric by assuming that a buyer would do so.
Is purchase price equal to enterprise value?
The answer to this question is a bit more complicated than it might seem. The short answer is no, purchase price is not always equal to enterprise value because if there’s only a minority buyout then price is not equal to valuation. For example, if a company’s EV is $100 and it sells 80%, then the purchase price is $80. Moreover, even if the company is selling 100%, purchase price only equals enterprise value when the latter is calculated using a DCF model, not a market cap model.
DCF Model vs Market Cap Model
In the formula for enterprise value, the primary metric is market value of equity. There are two primary ways of calculating it: (1) using a discounted cash flow model, and (2) using a simple market cap model.
The DCF methodology calculates the intrinsic value of a company based on its future cash flows. It does so on the basis of free cash flow, which does not factor in debt. In this way, the DCF model shows 100% value of the company based on expected performance. We can use this as the basis for an evaluation. You can see an example of the DCF method below.
However, the market cap methodology is not used in buyout scenarios. It simply takes the value of outstanding shares multiplied by the stock price, adds debt, and subtracts cash. It does not represent the value based on future cash flows, but it’s very useful as a quick reference for investors. You can see an example of the market cap method below.
Is enterprise value the same as equity value?
Enterprise value is not the same as equity value. Equity value is equal to the market value of shares, whereas enterprise value is equal to the market value of shares, plus debt and minus cash. It’s important to note that equity value for private companies can only be calculated using the DCF model, whereas for public companies it can be calculated using the market cap method.
Is enterprise value the same as market cap?
Enterprise value is not the same as market capitalization (market cap). Market cap is the number of outstanding shares times the share value, whereas enterprise value is equal to market cap plus debt and minus cash. It’s important to note that market cap can only be calculated for public companies; the equivalent for private companies is market value of shares (enterprise value – debt + cash).
Is enterprise value the same as fair market value?
Enterprise value is not the same as fair market value of shares; however, it is the same as fair market value of the company. Fair market value as a concept means “what a reasonable investor would pay.”
Because the fair market value of shares represents market cap (i.e the trading price of shares is what a reasonable investor would pay), we need to add debt and subtract cash to get enterprise value. However, if we use the DCF model to calculate enterprise value (i.e what a reasonable investor would pay) and consider this the fair market value of the company, then enterprise value and fair market value are the same.
How to Calculate Enterprise Value
As discussed, there are two ways to calculate enterprise value. The first is using the DCF model and the second is using market capitalization (public companies only).
How is enterprise value calculated?
Using the DCF model, enterprise value is calculated based on future cash flows. Using the market capitalization model, EV is calculated starting with current stock price.
Let’s look at an example of both.
Enterprise Value DCF Model Example
The DCF model determines a company’s inherent value using future cash flows plus a terminal value. In Excel, we have to build a forecast for future free cash flow in order to calculate the enterprise value. While a description of this forecast is outside the scope of this article, you can see a complete example in the article 3 & 12 Month Cash Flow Projection: Excel Guide & Template, as well as download the Excel I use in the below example of WalMart Inc. here:
Free WalMart 2021 EV & EqV Model Here
In the images below, you can see how I calculate net present value (NPV) and terminal value:
Shown above is the formula for NPV. I use XNPV so I don’t have to worry about dates.
Shown above is the formula for terminal value that gets added to NPV, the sum of which calculation is enterprise value. Once we subtract debt and add cash, we arrive at an equity value of $237.58 per share. Let’s see how that compares to the market cap method.
Enterprise Value Market Cap Model Example
In the same image above, we market cap of $393,038. Once we add debt and subtract cash, we arrive at the per share equity value of $139.52.
There’s a reason the per share equity values are different! The DCF model suggests that the actual value of the company ($237.58/share)is greater than what it is trading at right now($139.52/share)1.
Enterprise Value from Balance Sheet
You cannot calculate enterprise value from the balance sheet alone, but you do need total debt and cash (both are balance sheet accounts) in order to make the calculation.
Moreover, as you can see in the Excel example below, the DCF enterprise method requires we project the company’s balance sheet items into the future in order to understand its cash generation. To create this projection, we have to forecast capital expenditures and working capital, as well as any prepaid expense evolution. This requires additional schedules like the following:
For the most part, my forecast methodology is straightforward. However, the blue cells you see for fixed asset additions, or CAPEX, were guesswork numbers used to neutralize an otherwise unrealistic cash growth rate.
Can enterprise value be negative?
In short, enterprise value calculated using the DCF method can be negative when future cash flows are negative, and EV calculated using the market cap methodology can be negative if cash is greater than market cap and debt. Both of these scenarios, however, are highly unlikely and would rarely represent an attractive project to managers or investors.
What does negative enterprise value mean?
A negative enterprise value means 1 of 2 things: either (1) the company expects to be cash negative in the future (DCF) or (2) the company has more cash than equity and debt. In laymen’s terms, a negative enterprise value is a huge red flag and should, except in the case of a turnaround M&A activities, be avoided.
We’ve sufficiently covered what enterprise value is and how to calculate it. Now let’s turn our attention to analyzing enterprise value with the use of financial ratios.
Enterprise Value and Financial Ratios
First and foremost, it’s important to remember that all ratios involving EV must compare pre-debt metrics. Why? Because enterprise value ignores the impact of debt on the valuation.
If this isn’t clear, think again about our two EV methods. In the case of DCF, we use Free Cash Flow to determine enterprise value. FCF excludes interest from the P&L and ignores financing activities (debt) entirely. In the case of market cap, we only use equity value as the base, then add debt (which means it excludes debt impact on company value) and subtract cash (to imitate the purchase scenario logic mentioned at the start of the article).
All that to say, financial ratios using EV must compare to pre-debt metrics. What are these pre-debt metrics? Four common ratios are:
- EV/Sales
- EV/Revenue
- EV/Equity Value
- EV/EBITDA
- EV/Free Cash Flow
Enterprise Value to Sales
Enterprise value/Sales shows how many time greater the intrinsic value of the company is compared to its sales. This number is almost always greater than 1, and lower EV/Sales multiple usually indicate lower margins. Financial ratios should always be compared across companies and/or over time in the same company.
Enterprise Value/Revenue
While in many cases finance people refer to revenue and sales as the same thing, they can be different. Sales is the value received from direct exchange of the company’s core product or service, whereas revenue can include sales and other operating revenue such as gains from disposals, interest income, and dividend income.
The EV/Revenue ratio is thus considered more reflective of the accounting state of the company, but less reflective of its performance. The number is almost always greater than 1, and as with EV/Sales the lower the number the more indicative of lower margins. Financial ratios should always be compared across companies and/or over time in the same company.
What’s a healthy EV/Revenue ratio?
Using the market cap method, I calculate the EV/Revenue ratio for 10 high-performance US companies. On average, a healthy EV/Revenue ratio is 2.43. The data for this calculation is in the following table.
| Company | EV/Revenue | Year | Source |
|---|---|---|---|
| Apple | 6.68 | 2020 | Yahoo Finance |
| Amazon | 4.00 | 2020 | Yahoo Finance |
| Johnson & Johnson | 5.43 | 2020 | Yahoo Finance |
| Costco | 0.96 | 2020 | Yahoo Finance |
| The Home Depot | 2.85 | 2020 | Yahoo Finance |
| CVS Health | 0.69 | 2020 | Yahoo Finance |
| UnitedHealth Group | 1.57 | 2020 | Yahoo Finance |
| McKesson Corp | 0.15 | 2020 | Yahoo Finance |
| Cardinal Health | 0.12 | 2020 | Yahoo Finance |
| Exonn Mobile | 1.81 | 2020 | Yahoo Finance |
Enterprise Value to Equity Value
Enterprise value to equity value, or EV/EqV, shows the weight of debt in the EV calculation. For example, if equity value is 20 and EV is 100, then the EV/EqV is 5, and net debt (debt minus cash) accounts for 4 times equity in the EV. This ratio can be used as a quick reference across companies to understand the relationship between EV, EqV, and net debt.
This number is always greater than 1, unless enterprise value is negative. In that case, net debt is the source of the negative value and you should explore why cash reserves are so high — it’s not necessarily a bad thing. Financial ratios should always be compared across companies and/or over time in the same company.
Enterprise Value to EBITDA
The most common EV ratio in my experience is EV/EBITDA. It tells you how much enterprise value a company generates from operating profit less depreciation and amortization expenses. This is useful because it help investors understand value from the current operational efficiency of the company, which is not deflated with costing on LT assets (depreciation and amortization).
What’s a healthy EV/EBITDA ratio?
Using the market cap method, I calculate the EV/EBITDA ratio for 10 high-performance US companies. On average, a healthy EV/EBITDA ratio is 16.52. The data for this calculation is in the following table.
| Company | EV/EBITDA | Year | Source |
|---|---|---|---|
| Apple | 21.76 | 2020 | Yahoo Finance |
| Amazon | 29.34 | 2020 | Yahoo Finance |
| Johnson & Johnson | 16.17 | 2020 | Yahoo Finance |
| Costco | 20.97 | 2020 | Yahoo Finance |
| The Home Depot | 16.27 | 2020 | Yahoo Finance |
| CVS Health | 10.24 | 2020 | Yahoo Finance |
| UnitedHealth Group | 15.73 | 2020 | Yahoo Finance |
| McKesson Corp | 9.06 | 2020 | Yahoo Finance |
| Cardinal Health | 7.23 | 2020 | Yahoo Finance |
| Exonn Mobile | 18.45 | 2020 | Yahoo Finance |
Enterprise Value to Free Cash Flow
In the DCF method, EV to Free Cash Flow compares the NPV of future cash flows (EV) to the most recent year’s free cash flow. It’s arguably the easiest metric to understand because the basis for both numbers is cold hard cash. The higher the EV/FCF, the higher the projected growth for FCF. It may be useful the explore the Excel I’ve included in the article to better understand.
Using the market cap method, however, EV to free cash flow will be different, and it’s more difficult to conceptualize what the ratio represents. When EV equals market cap plus debt and minus cash, you’re not comparing like-for-like numbers. On the other hand, it’s much easier to quickly calculate EV using the market cap method, so this has become more common in practice.
EV/Free Cash Flow is almost always greater than 1. Financial ratios should always be compared across companies and/or over time in the same company.
Conclusion
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- This model of WalMart Inc. is intended for educational purposes only and should not be considered investing advice [↩]
