One Of The Most Important (Yet Overlooked) Valuation Measures
When you really think about it, value investing boils down to buying stocks that trade for less than they are really worth.
We use terms like “intrinsic value” to discuss a stock’s true worth. But, of course, this can be subjective…
Some value investors only look at present assets/earnings and place no value on future growth. Other value investors include estimates of future growth and cash flows to determine what a stock is “really” worth. Despite the different methodologies, it all comes back to trying to buy something for less than its actual value.
To help investors better understand how to determine a stock’s true value, let’s discuss one of the most important (yet overlooked) valuation measures out there: Enterprise Value.
As you’ll see in a moment, by looking beyond more simplistic measures like market capitalization, investors can get a much firmer grasp of how a company is valued. More importantly, they’ll be one step closer to determining how it should be valued.
What Is Enterprise Value?
You can find a company’s enterprise value on many financial websites. But many investors tend to overlook it — either because they don’t care about value or they are simply unaware of what it actually means.
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 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.
Now let’s have a look at an example to better understand. Let’s assume Company XYZ has the following characteristics:
Shares Outstanding: 10,000,000
Current Share Price: $5
Total Debt: $10,000,000
Total Cash: $5,000,000
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 = $55,000,000
Why Enterprise Value 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, this is not an accurate reflection of a company’s true value in most cases. Enterprise value considers much more than just the value of a company’s outstanding equity.
Enterprise value considers 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 enormously impact a 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 consider cash and debt. 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. This value can then be compared to the overall market, the broader industry in which the company operates, or against the company itself historically.
All methods provide information that can help an investor decide whether the company in question is a good value.
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