Enterprise value is a business valuation calculation that measures the worth of a company by comparing its stock price, outstanding debt, and cash and equivalents in the event of a company sale. In other words, itís a way to measure how much a purchasing company should pay to buy out another company. A lot of times this is called the takeover price because itís amount of money required to purchase 100 percent of a business and take it over.
In business there are generally two ways to grow a company. Some companies grow internally by developing new products and lines to reach new customers. While this strategy is great, it can be slow and costly. Developing new products and marketing to new customers isnít cheap. Thatís why many companies choice a different growth strategy. They expand by acquisition. Rather than developing new products, they just find companies that are already successful in those spaces and purchase them. This is where business valuation methods are important.
Traditionally, the market capitalization method is used to compute the value of company by multiplying the outstanding shares by the fair market value per share. This gives investors a good understanding of the company, but it doesnít take into account other balance sheet items like debt and cash. Enterprise value, on the other hand, considers the entire economic value of a company using these other accounts. Thatís how to value a company the right way.
The enterprise value formula is calculated by adding the outstanding debt and subtracting the current cash from the companyís market capitalization. Hereís what the basic equation looks like.
This is the simplified version of the enterprise value equation that only looks at debt and cash. A more sophisticated investor would also want to look at the impact of preferred shares, minority interests, cash equivalents, liquid inventory and other investments. This only makes sense. The purpose of the business valuation calculator is to measure the total economic worth of a business and come up with a takeover price. Investors typically use this more detailed equation.
Letís take a look at an example. Billís Music is a local music store with a prime location. Bill has been running this store himself for ten years and has been approached by Guitar Center (GC) recently to acquire his business because of the great location and local market. Bill thinks his music store is worth $200,000 because thatís how much he makes every year, but he has no idea how to do a true business valuation of his company. Hereís what Billís balance sheet looks like:
- Cash: $50,000
- Inventory: $15,000
- Liabilities: $25,000
- Common Stock: $75,000
- Retained Earnings: $15,000
Using the enterprise value method, Guitar Center would calculate Billís Music to be worth $35,000. Since Guitar Center can use Billís inventory, itís considered liquid and is treated as cash. The companyís retained earnings isnít used in the computation because the stock price theoretically already reflects the retained earnings of the company. In other words, profitable companies with higher retained earnings will usually have higher stock prices and cash reserves.
As you can see, this measurement is used to come up with a business valuation or take over price. GC would acquire all of Billís Music for $35,000. This includes the entire business and balance sheet. In other words, Guitar Center would receive all of the cash, inventory, and stock as well as take on all of Billís debt. That is why the enterprise value method is so much more accurate than the market capitalization method.
If GC simply used the MC approach, it would value the Billís Music at $75,000 because thatís the price of the outstanding common shares. Obviously, this would drastically understate the true cost of acquiring Billís firm because it doesnít take into account the fact that Bill owes his creditors $25,000 and GC would have to pay them back after it acquires Bill.
The MC method is a good shorthand calculation because itís easy to do and doesnít take much research. All you need to do is look at the equity section of the balance sheet and compute the value of outstanding common shares, but this is not how to value a business completely. As with any company, there are many moving parts and each section of balance sheet should be examined in the estimated purchase price.
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