Enterprise Value - an alternative way of estimating the value of companies

Most often, the value of a company is determined by its capitalization. However, there are still alternative measures of enterprise value estimation. One of them is EV, i.e. EnterpriseValue. In today's article, we will present the definition, formula and application of this indicator.

Definition of Enterprise Value

Pricing by market cap alone has its weaknesses. The effective cost of acquiring a business is often very different from the capitalization itself. What it comes from? One of the reasons is the need to manage the company's debt. However, it is not the nominal value of the interest-bearing debt itself, but its real value (less cash and cash equivalents). Enterprise Value is a measure that allows to estimate the "real" price of taking over a company.

The formula for the value of the enterprise is as follows:

EV = market cap + interest debt - cash and cash equivalents

In the case of interest debt, both short-term and long-term debt are included, but trade liabilities are omitted. Convertible bonds to stock should be treated as an ordinary interest debt. In the case of companies that run an employee pension fund, unfunded pension liabilities should be added to the value of the debt. The indebtedness should also be increased by the liabilities resulting from the share options granted to employees.

What is the EV talking about?

Enterprise Value can be seen as the theoretical acquisition price. After all, the acquiring company has to manage the debt of the acquired company and can use the cash resources of the acquired company. The company's capitalization, in turn, approximates the company's potential to generate future net cash flows. It is worth remembering that market capitalization is an estimated company valuation to shareholders, while Enterprise Value is a company valuation for shareholders and creditors of the company. It is worth noting, however, that EV growth is not tantamount to generating value for shareholders. For example, taking over a competitor at an inflated price with debt increases EV, but does not necessarily translate into an increase in shareholder value. Conversely, selling unprofitable parts of a business to reduce debt reduces Enterprise Value, but can increase ROIC.

Use of EV

Enterprise Value is used as one of the multiplier components for enterprise valuation. The advantage of using EV is the leveling of differences in the structure of liabilities and assets. This is because Enterprise Value already includes net debt adjustments. There are quite a lot of multipliers using EV. Each of them has its advantages and disadvantages. These include:

• EV / EBIT,
• EV / EBITDA,
• EV / S,
• EV / GP,
• EV / FCF.

EV / EBIT

This is the ratio that divides Enterprise Value by the generated EBIT (simply operating profit). The lower the ratio, the theoretically the enterprise is more underestimated. The disadvantage of this indicator is its focus on the accounting understanding of profit. The generated operating profit does not always have to translate into positive free cash flow. Another problem is including depreciation in costs. For example, an industrial enterprise with a new machine park has higher depreciation than a company operating in the same industry, but which cuts expenditure on the renovation of the machine park (production assets mostly depreciated).

EV / EBITDA

This is one of the most popular uses of Enterprise Value. EBITDA it is EBIT increased by depreciation. This means that it "cleans" the result for depreciation costs that are non-cash. In theory, EBITDA should be an approximation of the FCF (Free Cash Flow), but does not take into account changes in working capital. Some companies may generate accounting profits, but the cash generated will be “eaten up” by inventory expenses or will be frozen in uncollected receivables. EBITDA also does not provide information on the necessary capital expenditure to restore the company's production capacity (the so-called CAPEX). This is especially important in the case of enterprises from the "old economy".

EV / S

The EV / S ratio is simply dividing the company's value by revenues. It is a particularly popular indicator for the valuation of technology companies which, due to the allocation of large funds for development, are not yet profitable. The disadvantage of such a solution is the lack of differentiation between companies in terms of the potential to generate profitability and the method of revenue recognition. In the case of potential, another thing is a SaaS company, which can generate a net margin of 30% in the future, and another thing is a technology company that operates in a homogeneous market and has the potential to achieve a 10% net margin. When recognizing revenues, it is worth bearing in mind what the company's business model is. For example, a marketplace that only charges commission on transactions and collects 5% of the transaction value (and treats only the commission as income) is something else, and e-commerce, which itself sells products purchased from suppliers, is another thing. In such a situation, it recognizes the entire sale in revenues, not the value of the commission. Below is a summary of the examples.

Source: own study

EV / GP

This is otherwise Enterprise Value divided by Gross Sales Profit. This solution allows you to study fast-growing companies that generate a high margin on sales, but which spend much larger amounts on business growth. For example, these could be customer acquisition expenses or research and development costs. The disadvantage of such a solution is that it is not known whether the company will achieve the assumed profitability in the future. Many of the fast growing companies have not been able to grow quickly and achieve satisfactory profitability.

EV / FCF

This is the measure that divides Enterprise Value by Generated Free Cash Flow (FCF). This indicator is applicable to slow growing companies. In the case of growth companies, the above-mentioned measure does not fulfill its function because the company still has high costs resulting from investing in the growth of the business scale.

Summation

Enterprise Value is used in multipliers that allow companies to be compared with each other in the same industry, but with different asset structures. EV is the result of adding the net debt value (debt less cash held) to the capitalization. Despite its usefulness, the indicator also has its drawbacks. One of them is the questionable usefulness of using EV in determining the effectiveness of invested capital. For example, a debt taken may be used to take over that destroys shareholder value (overpaying for a competitor). EV will not "catch" such a situation because it focuses only on the value of capitalization and net debt value.