What it means
The idea is to value the operating business rather than the way it happens to be financed. Two companies with identical operations can have very different share prices simply because one is loaded with debt and the other is not, and enterprise value strips that difference out.
Cash is deducted because a buyer effectively gets it back on completion. If you pay $100m for a company holding $10m of cash in the bank, your real outlay for the business itself is $90m, and enterprise value reflects that.
Debt is added because the buyer inherits the obligation to repay it or must refinance it. The same logic extends to other claims that sit ahead of ordinary shareholders, including preference shares, non-controlling interests in subsidiaries and, in careful analysis, unfunded pension deficits.
Enterprise value is mainly used as the numerator in valuation multiples such as EV/EBITDA and EV/Sales. Because both the top and bottom of those ratios sit above interest and financing choices, they allow fairer comparison across companies with different capital structures.
One caution is that enterprise value uses market values, so for a listed company it moves every day with the share price. For a private business the equity value has to be estimated in the first place, which means the resulting enterprise value is only as reliable as that estimate.
In practice
Real-world examples.
Example
A private equity firm screening acquisition targets ranks them on EV/EBITDA rather than price-to-earnings, because several of the candidates carry heavy debt that would distort any comparison based on share price or reported profit.
Example
A founder is offered "$40m for the business" and assumes that is what lands in her account. Because the offer is expressed as an enterprise value and the company carries $9m of net debt, the equity proceeds before fees are closer to $31m.
Example
An analyst comparing two supermarket chains finds one trades on a higher share price multiple but a lower EV/EBITDA. Once the leases and borrowings of both are brought into the picture, the apparently more expensive chain turns out to be the cheaper business.
Formula
Calculation
Total enterprise value = Market capitalisation + Total debt + Preference shares + Non-controlling interests - Cash and cash equivalents
A listed engineering group has 25,000,000 shares trading at $18 each, so its market capitalisation is 25,000,000 x $18 = $450,000,000. Its balance sheet shows total borrowings of $120,000,000, no preference shares or non-controlling interests, and cash of $40,000,000.
Enterprise value is therefore $450,000,000 + $120,000,000 - $40,000,000 = $530,000,000. If the group reports EBITDA of $53,000,000, the EV/EBITDA multiple is $530,000,000 / $53,000,000 = 10.0 times. Working backwards also holds: taking the $530,000,000 enterprise value, deducting $120,000,000 of debt and adding back $40,000,000 of cash returns the $450,000,000 of equity value.Case study
Seen in the real world.
Pelham Valve Systems is an entirely invented manufacturer presented here as an illustrative case. Its two founders received an approach from a trade buyer offering an enterprise value of $86m, and the pair spent a weekend planning what to do with $43m each.
Their adviser worked through the bridge from enterprise value to equity value the following Monday. Pelham carried $19m of bank debt, a $4m shareholder loan and $3m of cash, so the equity value was $86m less $19m less $4m plus $3m, which came to $66m before transaction costs and a $6m escrow held back for two years.
The deal still went ahead and was a good outcome, but the founders negotiated harder on the escrow once they understood how the headline number translated. Their adviser's standing advice afterwards was blunt: never celebrate an enterprise value, because the only number that reaches a seller's bank account is the equity value after the net debt bridge and the completion adjustments.
Watch out
Common mistakes.
- Treating an enterprise value offer as the amount the shareholders will receive. Debt and other claims must be deducted and cash added back to reach the equity value.
- Using the book value of equity instead of market capitalisation. Enterprise value is built on market values, and book equity can be wildly different.
- Deducting all cash without asking how much is genuinely surplus. Businesses need working cash to trade, and a buyer will usually argue that some of the balance is operational rather than free.
Questions
People also ask.
Why is cash subtracted rather than added?
Because the buyer acquires that cash along with the company and can use it to reduce the effective purchase price, so it lowers the true cost of the business.
Can enterprise value be lower than market capitalisation?
Yes, whenever a company holds more cash than debt, which is common among profitable technology businesses.
Is enterprise value the same as the purchase price?
Not exactly, since the final price also reflects working capital adjustments, escrows, earn-outs and transaction costs agreed in the sale documents.
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