What It Is:
Enterprise value represents the entire economic value of a company. More specifically, it is a measure of the theoretical takeover price that an investor would have to pay in order to acquire a particular firm.

Enterprise value is calculated as follows:
Market Capitalization + Total Debt - Cash = Enterprise Value

Some analysts adjust the debt portion of this formula to include preferred stock; they may also adjust the cash portion of the formula to include various cash equivalents such as current accounts receivable and liquid inventory.

How It Works/Example:
Let's assume Company XYZ has the following characteristics:

Shares Outstanding:  1,000,000
Current Share Price:  $5
Total Debt:  $1,000,000
Total Cash:  $500,000

Based on the formula above, we can calculate Company XYZ's enterprise value as follows:
($1,000,000 x $5) + $1,000,000 - $500,000 = $5,500,000

Why It Matters:
When attempting to gauge the overall value Wall Street has assigned to a firm, investors often look exclusively at market capitalization (calculated by multiplying the number of outstanding shares by the current share price). However, in most cases this is not an accurate reflection of a company's true value. Enterprise value considers much more than just the value of a company's outstanding equity.

More specifically, enterprise value considers the fact that an acquirer must also shoulder the cost of assuming the acquired company's debt. Additionally, enterprise value incorporates the fact that the acquirer would also receive all of the acquired company's cash. This cash would effectively reduce the cost of acquiring the company.

Debt and cash can have an enormous impact on a particular company's enterprise value. For this reason, two companies may have the same market capitalizations but may sport very different enterprise values. For example, a company with a $50 million market capitalization, no debt, and $10 million in cash would be cheaper to acquire than the same company with $30 million of debt and no cash.

The media, Wall Street, and major corporations often cite various valuation measures -- such as P/E ratios -- without mentioning the impact of debt obligations and cash. However, at times this can be very misleading, as ratios like P/E multiples don't take cash and debt into consideration. The reason for this is simple -- the "price" value in these ratios reflects only the value of a firm's equity.

To get a better sense for a company's true valuation, many analysts and investors prefer to compare earnings, sales, and other measures to enterprise value.

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