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Cost of Financial Illiteracy: How to Calculate Enterprise Value

If you are looking for the formula and explanation of Enterprise Value scroll down through this post.  The first part of the post helps to provide some context about how Enterprise Value and Market Capitalization are different.  If you are looking for a process to help you estimate the enterprise value of a private company check out this post.

Some excerpts from an executive suite near you . . . .

Able Widget Company CEO to his CFO: “Have you seen what the markets have done to Baker Widget Company’s stock price?  They’re down over 55% since the start of the credit crisis.  Their market cap is half of their revenues.  I smell a great deal for us here.”

Able Widget Company CFO: “While we can’t raise any debt to do this deal in today’s market we do have a good chunk of cash.  Perhaps a combination of a cash and stock deal could finally convince those guys to sell.  We’ve talked to these guys off and on for years – you don’t need to involve those investment bankers — You should give them a call and see what’s up!”

A few days later the Able Widget CEO finally connects with the Baker Widget CEO.  “Hey Bill, how are things going these days?  It sure seems like the market has taken a hard turn against you guys.  Maybe now is the time we could finally execute on that deal we’ve talked about all these years.  I’m pretty sure my board would support a transaction that is a 33% premium to where you guys are at right now.  What do you think?”  After a few moments Bill, Baker Widget CEO responds “Jack, I think you’re missing something regarding our valuation.  Have you taken a look at our balance sheet?  When you look at our net debt position plus our preferred shares our enterprise value is more like 1.75x our revenues.  To get our board’s interest any offer would have to be a premium over that number, unless you have enough cash to cover our market cap, retiring the debt, and paying off the preferred.”  Jack, Able Widget’s CEO gulps and says “Gee Bill, that’s kind of interesting.  Let me check with my guys and I’ll get back to you.”  Surprisingly Bill never hears back from Jack.

With the precipitous decline of the stock market most public as well as private companies are worth significantly less today than they were a year ago.  Yet many executives have a hard time answering a basic question – what is a company worth?  For public companies many people just look at the market capitalization reported on the various stock tracking sites.  Market capitalization is equal to the number of shares outstanding times the current stock price.  Market cap, however, fails to assess all of the variables that determine the value of a company.  Enterprise value is a much better measure. 

Enterprise value is cost you would have to pay to purchase a company at its current stock price.  This price includes not only the cost of the company’s equity (aka Market Capitalization), but the cost to retire any debt less any cash or marketable securities on hand.  A simple formula to calculate Enterprise Value is Market Capitalization + Debt – Cash. 

Two companies could have the same market capitalization but radically different Enterprise Values.  Let’s take a look at two public companies – SkyWest and WebMD.

 

SkyWest

WebMD

Market Cap $1.04 Billion $1.24 Billion
Debt $1.79 Billion $0
Cash $718.8 Million $332.6 Million
Enterprise Value $2.11 Billion $903.8 Million

Even though SkyWest’s market cap is about 20% lower than WebMD’s, and it has twice as much cash, its enterprise value is over twice the size of WebMD’s due to the size of their debt.  Most stock tracking services provide some type of ‘key statistics’ function where they calculate enterprise value for you.  Yahoo’s is perhaps the best.  Here’s an example of Microsoft’s key statistics.

Enterprise Value is a bit more complex than just market cap + debt – cash.  Depending on the nature of the company you may have to consider the value of minority interests, the value of associate company, and preferred equity.  The complete formula to calculate Enterprise Value is:

Enterprise value =

 common equity at equity value

 + debt at market value

 + minority interest at market value, if any

 – associate company at market value, if any

 + preferred equity at market value

 – cash and cash-equivalents.

As executive teams go hunting for cheap acquisition targets they need to consider the full cost of acquiring a potential acquisition candidate.  To effectively calculate enterprise value you really need to look at an acquisition candidate’s recent financial statements to get a complete picture.  Often the various stock tracking services will not do a perfect job in calculating enterprise value.  Items like convertible debt, preferred stock, long term contractual liabilities, and restricted cash don’t get properly assessed and as a result an inaccurate number is reported.

Another little tidbit to consider is a concept known as surplus cash.  Every company needs cash to operate.  Sometimes executives, bankers, or boards simply look at the cash and marketable securities a firm has on hand when they calculate Enterprise Value.  This can cause a problem when you start looking at what the companies may look like on a combined basis.  Rather than look just at the cash and marketable securities items on the balance sheet you should calculate what ‘surplus cash’ is actually available in the business.  An easy way to do that is to subtract short term liabilities from short term assets to get a rough figure of surplus cash.  The modified Enterprise Value formula would then be Market Cap + Debt – Surplus Cash.

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6 Responses to “Cost of Financial Illiteracy: How to Calculate Enterprise Value”

  1. Reader Says:

    Wow! Thank you very much!
    I always wanted to write in my site something like that. Can I take part of your post to my blog?
    Of course, I will add backlink?

    Regards, Timur Alhimenkov

  2. Jim Spence Says:

    Hello While searching for Blogs about financial aid formula I found your site Financial Illiteracy: How to Calculate Enterprise Value | DevelopmentCorporate. Thank you for the effort you have put in.

  3. elena Says:

    Thank you for your article~ it’s a great help!!

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