What it means
Market capitalisation, which is the share price multiplied by the number of shares, only tells you what the owners' stake is worth. A buyer who acquires the whole company also takes on its borrowings, and gets the benefit of any cash it holds.
Enterprise value adjusts the market value to reflect both. The logic is easy to picture with a house.
If you buy a house worth $500,000 that has a $200,000 mortgage, you pay the seller $300,000 for the owner's equity and also take over the $200,000 debt, so the whole house costs you $500,000. In the same way, a company's enterprise value covers both the equity and the debt.
Cash is deducted because it reduces the real price. If a company holds $50,000,000 in cash, a buyer can use that cash to repay part of the purchase cost, so the net price is lower.
Some analysts deduct only surplus cash, leaving out cash that is needed to run the business day to day. A fuller calculation also adds preferred shares and non-controlling interests, which are the parts of subsidiaries owned by outsiders.
Some analysts include lease liabilities and pension deficits as debt-like items. The choices should be applied consistently when comparing companies.
Enterprise value is useful because it is not affected by how a company is financed. Two similar businesses, one with debt and one without, will have different market capitalisations but should have similar enterprise values.
This is why valuation multiples such as enterprise value to EBITDA are used to compare companies. It is an estimate, not a fact.
Market values change daily, debt and cash balances come from the latest accounts, and the figures may be out of date. For takeovers, the price actually paid usually includes a premium over the market value.
In practice
Real-world examples
Example 1
A private equity firm considers buying a listed retailer with a market capitalisation of $600,000,000, debt of $200,000,000 and cash of $80,000,000. The enterprise value is 600 + 200 - 80 = $720,000,000. This is the figure the firm uses when comparing the retailer with other targets.
Example 2
An analyst compares two telecom companies with similar operations. One has a market capitalisation of $1,000,000,000 and little debt, while the other has a market capitalisation of $500,000,000 and debt of $500,000,000. Their enterprise values are almost the same, which shows the businesses are similarly sized despite the difference in share value.
Example 3
A founder preparing to sell her company asks an adviser what the business is worth. The adviser values the operations at an enterprise value of $12,000,000, then deducts debt of $3,000,000 and adds cash of $1,000,000. The founder receives an equity value of $10,000,000 before fees and tax.
Think of it
Enterprise value is like the real price of a house including the mortgage you'd assume. Market cap is just the equity; EV includes the full cost to own it.
Formula
Calculation
Enterprise value = Market capitalisation + Total debt + Preferred shares + Non-controlling interests - Cash and cash equivalents
Suppose a company has 20,000,000 shares trading at $20 each, total debt of $150,000,000 and cash of $50,000,000. It has no preferred shares or non-controlling interests.
Market capitalisation = 20,000,000 x 20 = $400,000,000.
Enterprise value = 400,000,000 + 150,000,000 - 50,000,000 = $500,000,000.
A buyer would therefore be valuing the whole operating business at $500,000,000, even though the owners' shares are worth $400,000,000.Case study
Seen in the real world
Calder Freight is an illustrative, fictional logistics group that received an offer to buy all its shares at a price valuing the equity at $300,000,000. The board felt the offer was fair because it was 20% above the market price.
The chief financial officer looked at the whole picture. The company had $180,000,000 of debt and $30,000,000 of cash, so the buyer was really paying an enterprise value of 300 + 180 - 30 = $450,000,000.
She compared that with the group's EBITDA and with similar deals and concluded that the price was lower than comparable transactions. The board negotiated a higher offer. The illustrative lesson is that the headline price for the shares understates what a buyer is really paying for the business.
Watch out
Common mistakes
- Using market capitalisation alone to compare companies with different levels of debt.
- Forgetting to subtract cash, which overstates the price of the operating business.
- Mixing definitions, such as including lease liabilities for one company and not for another.
Questions
People also ask
What is the difference between enterprise value and market capitalisation?
Market capitalisation measures only the value of the shares, while enterprise value adds debt and deducts cash to show the value of the whole business.
Can enterprise value be lower than market capitalisation?
Yes, if the company holds more cash than debt, the enterprise value will be lower than its market capitalisation.
Why do buyers prefer enterprise value?
It reflects what they actually pay for the operating business after taking on debt and gaining cash, and it allows fair comparison across companies financed differently.