Enterprise and equity value are two different valuations of a company. The enterprise value indicates the worth of a company if it has to sell its business at the current market price. On the other hand, equity value is the total of the company’s shares, including loans by shareholders. But, why are enterprise value and equity value important? Read this article to know!
Investors usually concern themselves with the equity value of the company when they invest. However, there is a separate valuation or the enterprise valuation of a company that determines a company’s worth on the current market price. A company has to take care of both the enterprise and equity value of its business.
Here we will discuss enterprise value vs equity value.
What is enterprise value?
Enterprises need to cater to both their customers and investors. Companies’ customers are known through their enterprise value or EV.
EV represents the total monetary value of all of the company’s assets, excluding cash. While calculating the total worth of a business enterprise values gives a more comprehensive understanding than market capitalisation. It includes the business’s total market capitalisation amount and short and long-term debts.
Enterprise value allows other businesses and investors to compare companies with different capital structures, as the company’s value isn’t impacted by the capital structure.
While calculating EV, it is useful to understand the various parts it includes. The components that make up the company’s enterprise value are below.
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Market cap:
It represents the total value of a company’s outstanding equities – preferred and common.
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Debt:
All short and long-term borrowing of the company.
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Unfunded pension liabilities:
An amount that the company needs to set aside for pension payments in an unfunded form.
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Minority interest:
Companies subsidiaries with less than 50% equities. It can be added to market capitalization value for EV calculation.
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Cash and cash equivalents:
The total amount of cash along with all instruments that generate cash returns, like certificates of deposits, treasury bills, short-term government bonds etc.
The formula used for evaluating a company’s enterprise value is the following.
EV = (share price x number of outstanding shares) + total debt – cash
Importance of calculating enterprise value
An enterprise can grow via different routes; one such is through mergers and acquisitions. Enterprise value is important to determine a company’s acquisition cost.
When one company acquires another, it also acquires all its debts. The debt increases the cost of acquisition and cash flow decreases the cost. Hence, an EV is a more accurate representation of a company’s financial health than market capitalisation.
A company’s enterprise value can be negative if its cash flow is larger than the total market capitalisation and debt. It is a sign that the business isn’t using its assets efficiently. It can use idle cash for buybacks or expansions, research and development, pay rises, bonuses, or debt repayment.
What is equity value?
The equity value of a company refers to the total value of the company’s shares along with any loan from its shareholders. It represents the amount that will be left for the shareholders if the company pays all its debts. In other words, it is a value attributed to the equity holders of a company.
Enterprise value and equity value, both are common ways to evaluate the worth of a business. However, enterprise value is the current value of a business, while equity value offers a snapshot of the business’s current and potential future value. It is important to note that a company’s equity value isn’t fixed. It rises or falls depending on the fluctuation in the company’s stock prices.
How is the equity value calculated?
Here is a formula used for calculating equity value.
Equity value = Enterprise Value – total debt + cash
A second formula,
Equity value = number of shares x share price
The equity value captures the effect of the company’s value on its share price. To derive equity value from enterprise value, minus all debt and debt equivalents, non-controlling interests, and preferred stocks from the value and add cash and cash equivalents.
Enterprise value vs equity value
Both are important to determine a company’s worth but the purposes are different. Enterprise value measures the company’s core business, whereas equity value attributes the value available to equity investors.
Enterprise value helps experts and investment bankers to calculate a company’s worth during M&A. It allows analysts to calculate the value of a business without the capital structure.
On the other hand, equity value is a vital technique for retail investors interested in buying company stocks. It showcases the current and predicted future value of the business and how much the share price can appreciate in the future.
Equity value is also used for banks and insurance companies.
As a thumb rule, if the company’s value includes metrics such as a net change in debt, interest income, and expense, then equity value is the common method used for analyzing a company, instead of enterprise value.
Final words
The enterprise value tells how much it will cost to acquire the company. However, it has certain limitations, especially while comparing dissimilar companies. It simply tells how much a business will cost to acquire. Hence, if two companies have similar market capitalisation then one with less debt will cost less to acquire. But it doesn’t give clarity on how the company is using its debt. Some companies need to acquire significant debt to meet their working capital requirements.
On the other hand, equity value concerns itself with the equity aspect of the business, measuring how much returns a company can generate if one buys its shares.
It is important to know about equity vs enterprise value to make better investment decisions.
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