Understanding Market Capitalization and Enterprise Value (EV) with Examples
What is Market Capitalization ?
Market capitalization means the market value of equity shares of the Company. It is an important component of a Company’s valuation. It can be calculated as Share price multiplied by the total number of outstanding shares of the Company.
Example: ABC Limited shares are trading at $15 per share on 31st March 2020. The total outstanding shares are 1,000.
In this case, the market capitalization of ABC Limited is $15*1,000 = $15,000/-
This means that if a person wants to buy 100% shares of the Company, he will have to pay $15,000. Market capitalization measures the price at which a Company’s stake can be bought or sold. This is more of a price rather than value.
What is Enterprise Value?
Enterprise value is the measure of Total Value of the Company. While Market capitalization is the measure of value from equity shareholders perspective, Enterprise value measures the total value of the Company’s business (whether financed fully by equity or by both debt and equity). Therefore, all the ownership interest of both debt and equity shareholders is included in the Enterprise value of a Company.
In other words, Enterprise value (EV) is a more accurate and comprehensive measure of Company’s value as compared to Market Capitalization.
How is Enterprise Value calculated?
It is calculated as
Market Value of equity or Market capitalization of a company is the Share price Multiplied by the number of outstanding shares.
Market value of preference share is the share price of preference share (if listed) multiplied by the number of outstanding preference shares. If they are not listed and are redeemable then treat them as debt equivalent.
Market value of debt includes value of all the Long-term debt and Short-term debt (including bank loans, overdrafts etc.). If the debt is not listed, then consider book value of the debt.
Other long term/short term non-operating liabilities include pension, post retirement and other liabilities (like restructuring provision, legal liability etc.) which are financial liabilities and are not related to day to day operations of the Company. Such liabilities should be treated as debt equivalent to calculate Enterprise Value.
Minority interest is the value of subsidiaries held by minority shareholders.
Cash and cash equivalents include, cash, bank deposits and other liquid investments.
Other Long-term investments includes, long term deposits, investments held till maturity, investments held for sale, investments in equity shares/ bonds of other Companies. These are investments where Company’s usually park their surplus cash and are not directly related to the business operations of the Company.
Let us understand quickly how to calculate EV with the help of a simple example.
Example: ABC Limited shares are trading at $15 per share on 31st March 2020. The total outstanding shares are 1,000. The balance sheet of ABC as Limited as on date is as under.
Let us calculate the Enterprise Value of ABC Limited:
Market capitalization of ABC Limited is $15*1,000 = $15,000/-
Total short term and Long-term debt = ($200+$1500) = $1,700/-
Other non-operating liabilities = $50
Cash and cash equivalent = $100
Investment = $520
Value of Preference share and Minority interest is NIL
Where is Enterprise value used?
Enterprise value is generally used to measure the value of the Company or business for making acquisitions or divestments. The acquirer would be liable to pay both to the equity as well as debt financiers. This is why, Enterprise Value is used in making mergers and acquisition decisions.
Equity value multiples (P/E ratio) and Enterprise value multiples (EV/EBITDA, EV/EBIT etc.) are generally used to compare valuation of Companies in the same or different industries.
Equity multiples (P/E multiple) are impacted by non-operating income and expenses and financing decisions.Therefore, two Companies having different finance structure and same operating performance may differ in their P/E multiples.
EV multiples are not impacted by financing decisions and non-operating income and expenses. EV measures the full value of the business of the Company and EBITDA and EBIT measures profits from operating activities of the Company. Therefore, EV multiples generally give a better picture of valuation of two companies having different capital structure.
Enterprise Value is also used in financial modeling.. Analysts often model Free cash flows to firm (FCFF), which is cash flows to 100% owners of the Company. Present value of cash flows till perpetuity determines the Enterprise value of a Company.
Analysts measure the enterprise value through FCFF and then add cash and cash equivalents, investments, and reduce debt and debt equivalents to arrive at the equity value of the company. When they divide the equity value by the number of outstanding shares they get the target share price.
Enterprise value is the value of Company’s business. It is generally used to understand the acquisition price of a target Company (excluding acquisition premium). Also, EV multiples are used for comparison valuation of companies to identify under/over valued stocks. However, EV multiples are not always conclusive evidence of cheap or overvalued stocks. It has to be linked to actual operating performance of a Company as value may temporarily be impacted by market sentiments.
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