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Enterprise Value: The true test of value - Views on News from Equitymaster
 
 
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  • Oct 8, 2010

    Enterprise Value: The true test of value

    When we look at firms within the same industry they may appear similar at face value. They have similar business segments, similar sectoral risks, equal management competence etc. But, are they really the same?

    Some firms may be laden with debt. Some may have piles of unutilised cash. Some may have a low public float. So how do we normalize for all of these different aspects? How does one identify the total value of the company before buying into the shares?

    Market cap is one of the quickest way to gauge the size of the company:

    Market capitalization (market cap) = Share price * Shares outstanding

    But if someone wishes to buy all the shares in the company, just the market cap will not offer the true value of compensation to be paid.

    While the market cap will give the value of listed shares, there are still some missing elements.

    According to Wikipedia:

    "Enterprise value (EV) is an economic measure reflecting the market value of a whole business. It is a sum of claims of all the security-holders: debt holders, preferred shareholders, minority shareholders, common equity holders, and others."

    Enterprise Value = Market cap + market value of debt + minority interest - associate company + preferred equity - cash and cash equivalents.
    Enterprise value helps look at the entire value of the firm. This is definitely more than just the value of outstanding equity. After all both liabilities (debt) and equity help finance the assets of any company.

    For instance, if an investor wants to buy RCom, talks of which have been in the news of late, one cannot just buy out the stakes of the promoter and minority shareholders. There are some other large components lurking in the balance sheet. 81% of RCom's latest market cap is in debt. One would need to first pay off all the debt holders before buying out the firm. And how would the debt holders, be paid off? With any excess cash that the company has in its books.

    One usually sees that service companies, which have low assets, are usually debt free. Equity is enough to fund their limited physical assets, eg TCS, Infosys.

    On the other hand manufacturing companies with large asset bases such as Tata Steel or Tata Motors, need debt and equity to help fund their operating needs.

    So how does EV help in analysis?

    It helps determine the total value of a firm irrespective of its capital structure. P/E ratios depend on net income which can fluctuate due to write-offs, interest components etc. It can be impacted by the different capital structures of the company. On the other hand, EV based ratios (EV/EBITDA, EV/ operating income) are usually more stable since only operating profits are included

    It helps determine how the assets of a business are funded. This further helps in identifying good quality companies, i.e. companies with low debt and high cash. Furthermore, it also helps assign a takeover value to the company.

    When we acquire shares in a company, even if it is a negligible percentage, we should be careful in understanding which other parties have laid claims to the assets that help drive the business.

     

     

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    2 Responses to "Enterprise Value: The true test of value"

    Rahul

    Oct 30, 2010

    EV is what, its the original value of Enterprise. It helps the investor to find the value of company. Before Investing, one should check the Debt and assets of the company.Sometime debt value is more than Enterprise value so one should consider. One should go for IT company and Packaging Industry like Uflex.If anybody has confusion about investing then send me the mail.

    Thanks

    Like 

    VINAY

    Oct 8, 2010

    One would need to first pay off all the debtors before buying out the firm. And how would the debtors, be paid off? - DEBTORS MEANS RECEIVABLES. DID YOU MEAN "DEBT HOLDERS" I.E. LENDERS ?

    Like 
      
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