Enterprise Value Explained: Definition, Formula, Users, Limits

Enterprise Value: What It Is and Why It Matters

As a business owner, leader, or decision-maker, you know that understanding the true value of your small or midsized business (SMB) is critical if you want to grow, secure capital, or, eventually, sell. This true value is known as enterprise value (EV) and correctly calculating your EV can help you make smart, strategic decisions, both in the short and long term.

Let’s define EV, clarify the difference between it and market capitalization, and look at an easy, step-by-step formula you can use to determine your EV today.

What is Enterprise Value?

Enterprise value is a business valuation metric that estimates what it would cost to own an entire company, not just its publicly traded shares. This valuation metric includes the impact of debt and subtracts the amount of cash the business has on hand, giving potential buyers visibility into the financial health of a business before they invest in it.

The process of buying an operating business is similar to buying a house. Though purchasing a home is on a smaller scale than buying a business, it’s still a big investment, and knowing the home’s value before signing on the dotted line is critical. The total price you’ll pay is the purchase price plus the amount required to pay off the existing mortgage minus the cash you have available.

This formula is a simplified form of how to calculate enterprise value.

How to Calculate Enterprise Value

To calculate your operation’s EV, you need a practical, repeatable calculation, such as the one below:

EV = Market Capitalization (MC, current stock price multiplied by number of outstanding stock shares) + Total Debt (sum of short-and-long-term debt) – Cash and Cash Equivalents (liquid assets)

You can also add additional components, such as preferred stock (a fixed-income obligation) and noncontrolling interest (portion of the equity not owned by the company), to make sure you have a clear picture of the true cost of the operation. This formula would look like the following:

EV = MC + Total Debt + Preferred Stock + Noncontrolling Interest – Cash

When calculating your EV, there are a few things to keep in mind. For example, a company’s EV can be negative. This means its cash and cash equivalents add up to more than its market capitalization and debts. Having too much cash can suggest the company isn’t using its assets strategically, such as to pay off debts, expand, invest in research and development, and more, which creates lower value for investors.

Another thing to consider is the difference between market value and book value. The book value of a company is its total assets minus its total liabilities, and it helps investors know if the company is over or undervalued. The market value, on the other hand, is a dynamic price based on a perceived value by the market.

More often than not, the market value is higher than the book value, indicating that investors see positive growth in the future for the company based on its ability to generate profit via its total assets. EV is mainly a market value metric, but it’s not the only valuation metric out there.

Enterprise Value vs Market Capitalization

EV is considered the more comprehensive method for estimating the cost of owning a company, but market capitalization is another way investors can determine a business’s overall value.

Market capitalization (or market cap) is calculated by multiplying a company’s current share price by its total number of outstanding shares. Businesses are grouped together by market cap size, and, according to Investopedia, this valuation helps investors assess risk. “Larger-cap companies typically offer more stability but slower growth, while smaller-cap companies often have greater potential for growth but more risk.”

Both EV and market cap are important metrics, but EV provides a bigger picture for investors by including equity, debt, and cash in its formula. If an investor is comparing two companies before committing to a purchase, they will want to know each company’s total value—including its debt—before making a final decision.

Let’s look at an example that shows how an EV formula uses MC to help investors make a good purchase.

Step-by-Step Example

Company X and Company Y each have a market cap of $5 million. However, their cash and cash equivalents and their total debt differ. Using the simple formula noted above, here’s each company’s EV.

Company X has $600,000 in cash and cash equivalents and is $300,000 in debt.

$5 million + $600,000 – $300,000 = $5.3 million

Company Y has $950,000 in cash and cash equivalents and is $300,000 in debt.

$5 million + $950,000 – $300,000 = $5.65 million

Though the two companies had equivalent market cap valuations, their differing cash and debt load impact their overall value—something every investor should consider.

Importance of Enterprise Value in Business Decisions

The importance of enterprise value to businesses and investors is clear: EV provides a more complete evaluation of a company’s worth than other methods.

By accounting for debt and equity, it’s a valuation method that is capital structure neutral. In other words, when businesses or investors compare the business against competitors, they’ll get a clearer picture. EV is also used in financial ratios to measure a company’s performance, such as an EV/EBITDA Ratio (also known as enterprise multiple) and an EV/Sales Ratio.

These ratios are valuation tools investors can use to compare the value of a company against its debt hold and cash earnings. EV/EBITDA (earnings before interest, taxes, depreciation, and amortization) evaluates a company’s debt without including cash, helping investors see how different companies in the same industry compare.

EV/Sales Ratio looks at the value and amount of debt a company must pay off. Per Investopedia, “A company with a lower EV/sales multiple is often seen as more undervalued and therefore more attractive. The EV/sales ratio can be negative when the cash held by a company is more than the market capitalization and debt value. A negative EV/sales implies that a company can pay off all of its debts.”

EV also plays a vital role in other business valuation methods, such as the market, income, and cost approaches.

Market Approach

In the market approach, investors appraise a business by considering the market prices of other, similar businesses. This approach is predicated on the idea that investors will not pay more for one business than it would cost them to purchase a similar substitute. In this context, they use EV/EBITDA to evaluate a company’s total value.

Income Approach

The income approach focuses on the future cash flow and earnings of a business. It predicts how much economic value a business could generate tomorrow to place a value on that business today. This equity value is the value of a business that is available to shareholders after debts are subtracted from the EV.

Cost Approach

With the cost approach, investors evaluate how much it would cost to replace a business to determine its fair value. This method takes into account the EV of a business while considering how much it would cost to acquire another, or build a new, company like it.

How ERP Systems Help Manage Business Value

Calculating your enterprise value hinges on your access to real-time, connected data. With an integrated business management solution, like Acumatica Cloud ERP, your financial and operational data is stored in a centralized database and available to you 24/7.

With Acumatica’s advanced financial management software, you have instant insights into EBITDA, revenue, and profit margins. It provides cash flow management capabilities that enable you to see trends and spot inconsistencies, while Acumatica’s reporting capabilities ensure you can retrieve the information so necessary to establishing enterprise value.

Acumatica’s functionality and capabilities can help private equity firms determine EV. As Acumatica’s Bass Zanjani writes, “With native support for multiple entities, multicurrency environments, and industry-specific requirements, Acumatica aligns perfectly with the private equity mandate: create enterprise value quickly, efficiently, and repeatably across the portfolio.”

“Our cloud ERP [solution],” he continues, “is the strategic engine for portfolio optimization with a future proof AI-platform to accelerate portfolio value, drive EBITDA growth, and ensure [firms] are exit ready. [This] is a value proposition that stands alone in the market as the premier choice for M&A investors.”

FAQs Leaders Ask About Enterprise Value

• Can enterprise value be negative, and what does that mean? Yes, enterprise value can be negative. This means that a company is holding on to cash rather than investing/distributing it or paying off debt.
• Does enterprise value include cash? Yes, enterprise value includes cash. The formula to calculate enterprise value adds the market cap of a business to its total debt and subtracts its cash and cash equivalents to show a true valuation.
• Is enterprise value the price you pay in an acquisition? Not always. The enterprise value suggests the total value of a business, but the transaction price is typically adjusted based on its debt to cash ratio.
• How do you calculate enterprise value for a private company? A private company valuation can be done via three methods: Comparable Company Analysis, the Precedent Transaction Method, and the Discounted Cash Flow (DCF) Method. Check out this CFI article for more details.
• Which is better for valuation discussions: EV or market cap? EV provides a clearer picture of a company’s overall value by accounting for debt and subtracting cash. Market cap is a quick way to evaluate companies but lacks the depth of information provided by EV.

Enterprise Value in One Minute

EV helps you assign a value to a business using your balance sheet and financial data that is publicly available. The formula takes the market cap of a business, adds the business’s total debt to it, and subtracts its cash and cash equivalents.

By providing a realistic valuation of a company, EV establishes that business’s value proposition, helping all stakeholders—including potential ones—understand the company’s financial health and suitability for investment.

To learn how Acumatica can help you determine your EV, contact our experts today.