Enterprise Value (EV) Definition & How to Calculate | Economics
The enterprise value (EV), is the value that a company or business has for all its financial creditors (those that provide debt, such as banks) and for shareholders (who are investors).
This value can be calculated in two ways:
- Calculating the value of future cash flows
- From the accounting point of view.
In what follows, we will see each of the calculation methods, as well as an example in each case.
Company Value According to Future Cash Flows
The value of a company can be calculated as the present value of all its future cash flows (Free Cash Flows – FCF), discounted at a discount rate that is the weighted average of the risks / returns required by investors. This rate is the WACC (Weitghted Average Capital Cost).
Its calculation formula is the following:
In the following example, we can see how the value of company 1 (808) is higher than the value of company 2 (730). As indicated in the definition of the WACC concept, it is the weighted average cost of the two cost resources that a company has: financial debt and equity. Thus, a higher WACC means a higher cost for the company.
As in the example, a higher cost means a lower value of your future returns. This is so because, as a result, you will have to face higher expenses.
For its part, future cash flows can also be a reason for variation in the value of a company. In this example, we have compared two companies with the same WACC = 5%. In contrast, the future cash flows of company 4 are higher in year 2 (400) and year 3 (600) compared to company 3.
This has a direct impact on the value of the company in the future, with that of company 4 being higher as higher cash flows are expected.
Company Value from an Accounting Point of View
In this case, from the accounting point of view, the market value of the resources that finance the assets with cost will be the value of the company.
Its calculation formula is the following:
The market value of equity (FP) is known as market capitalization. It is calculated as the total value of the company on the stock market:
Market capitalization = No. of shares x Market price of a share.
On the other hand, the net financial debt (excludes the treasury), its book value must be expressed. In a disaggregated way, we could calculate the value of the company as:
EV = CB + D + AP – T
- CB: Market capitalization
- D: Debt
- AP: Preferred Stock
- T: Treasury and equivalents
The resulting company value must be the same.
Calculation of Company Value
The company value is calculated based on the market capitalization, to which we must add and subtract the following values. The formula is as follows:
Company value = Market capitalization + Market value of its debts – Cash and equivalents
The formula can be complicated in some cases, such as in the case that the company has off-balance-sheet debts, although it is not common, so for practical purposes this simplified formula is useful for the vast majority of cases.
Examples of Calculating Enterprise Value
A company has a market capitalization of 300 million euros. This company also has debts worth 150 million euros and cash in the amount of 50 million. The calculation of the enterprise value is simple:
Company value = 300 million + 150 million – 50 million = 400 million euros
Possible Problems in Calculating Enterprise Value
The main problem for calculating company value comes from the fact that it is not possible to know the market value of a company’s debts, since they are private debts that are not found in listed markets. In these cases, the most common is to use the book value of the debt as a good approximation to its real value.
Another problem may be that there are debts not reflected in the balance . In this case, we must analyze the memory, where these types of debts that the company must face in the future must be reflected.
Can there be a Negative Company Value?
Although it is usually very rare, it can be the case of companies with negative company value. This can occur in companies with cash on hand that exceeds the sum of their net debt and market capitalization.
Companies with negative company value tend to appear at times of maximum market depression and can be great buying opportunities if they are the product of market irrationality.