Assessing Enterprise Value

There are two methods for calculating enterprise value. The more complex of the two is most reliable because it is more rigorous.

The simple formula is:

So, if a company has 1.5 million shares outstanding and its current share price is $18, enterprise value is:

However, this formula is a bit simplistic: defining value simply in terms of market perception fails to recognize other important measures of financial health.

Consequently, many analysts prefer a more thorough approach, which adds together market capitalization, debt and preferred stock (minus cash and cash equivalents):

Suppose a company's market capitalization is $11 million, long-term debt amounts to $3.5 million, preferred stock is valued at $5 million, and cash and equivalents total $4 million. The calculation would be:

In the event of a company takeover, new owners take on debt as well as assets, cash and liquid assets. The more complex formula recognizes that all these factors contribute to value, and is likely to produce a more accurate picture—particularly since stock prices often fluctuate, and debt may be quite substantial.

• Market capitalization and enterprise value are sometimes used interchangeably by the financial markets, but strictly speaking they are not the same thing.
• The term "total enterprise value" is sometimes used to mean the more complex definition of enterprise value (by those who normally use the simpler method).
• Increasingly, value is defined as the total funds needed to finance a company (rather than in terms of the price/earnings ratio). This focuses less on returns in relation to accounting, and more on economic returns—in other words, the profits that a company is making on its supporting capital.
• This method is more likely to be used to assess companies that are relying on loans to finance their development, or that have paid high prices for assets or acquisitions.