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Enterprise value or EV is simply the total financial value of a business. It is used by businesses to determine how much a particular business is worth and also enables businesses to understand how much their own business is worth if they were to sell it to another party. It is considered a valuation metric and is an important value. The enterprise value takes into account the current share price which is also called the market capitalization and the net debt or the cost to pay off debt which is simply debt subtracted by cash. The enterprise value is used in a variety of metrics including valuation multiples.
The enterprise value provides a realistic idea of a company’s worth. However, in reality, things might be a little different. Oftentimes, a premium is added to the enterprise value after which the acquisition takes place. The reason for this is that there are cases when there are more bidders which means the premium can increase. Another reason is that the company may decide that it wants to sell its business at a higher price than the value so they can benefit from it and start off another venture. The supply and demand can also play a role in increasing the premium of the company.
Who is the enterprise value for? Which businesses should calculate the enterprise value using the enterprise formula? Businesses who have a wide gap between their debt and cash are the ones who should calculate their enterprise value. This is particularly true for those businesses who are thinking about acquisitions. If you are an acquirer then you can use the enterprise value as a way to determine the assets and debts that will come along with the business.
The enterprise value formula is as follows.
Enterprise value = Market cap + Debt - Cash
The enterprise value formula might seem a little confusing so here is why it is formulated the way it is. Many people often feel stumped when they see that debt is being added while cash is being subtracted. Let us start with the cash being subtracted. The reason for this is that when you are acquiring the company, you get the cash of the business too along with it. This means you ‘earned’ that cash because it is yours to keep upon acquisition.
You also need to pay the debt which is why it is added to the market cap. When you acquire the business, you are acquiring the debt as well which is why it is added to the equation when calculating the enterprise value of a business. For example, if you have acquired the business for $50 million and the business is $1 million in debt, then you are actually spending $51 million for acquiring the company. Although you may be directly paying the $50 million, you will be paying the $1 million eventually; perhaps after you start operating the business.
Sometimes, even though two businesses may have similar market capitalization, their enterprise value can have a large difference. This is generally the case when businesses have debt or when they have cash reserves. Enterprise value provides a more realistic and detailed insight into a business when compared to the market capitalization value which is why it is more important between the two metrics. Market capitalization is calculated by multiplying the share price by outstanding shares. In short, market cap gives you the total value of a business’s outstanding shares.
You might have heard of the stock price and its fluctuating nature. The stock price in isolation doesn’t hold a lot of value because it doesn’t provide enough meaning for businesses to make key decisions. This is why the outstanding shares are so important. Outstanding shares are used in the calculation of the market capitalization value which is why market capitalization is more valuable than simply the stock price at a given point. If a company trades at $50 per share and has 1 million shares then the market cap is $50 million.
Let us illustrate the difference between market capitalization and enterprise value with a simple example for the sake of clarity.
Let us say that a company ABC has a market capitalization of $20 million and has a debt of $10 million with no cash reserves. Another company DEF has a market capitalization of $20 million and has no debt but with a cash reserve of $2 million. When you calculate the enterprise value of company ABC it is $30 million while the enterprise value of company DEF is $18 million. That is a difference of $12 million even though the market capitalization of the two companies is the same! This is why companies should not simply base the value on the market capitalization and instead calculate the enterprise value.
For you to correctly calculate your enterprise value, you need to know the various components; the market capitalization, debt, and cash or cash equivalents. Stay on top of your finances with the help of TallyPrime, the business management software solution with advanced features. You can easily generate financial statements such as the balance sheet, cash flow statement, profit and loss statement, and many such statements. TallyPrime ensures you record every single transaction so you know exactly how much outstanding debt you have and how much cash you have in hand. This enables you to calculate your enterprise value.
TallyPrime doesn’t stop there. It has powerful features that encompass a range of useful functions. You can create invoices with TallyPrime with a host of options to personalize it. You can process employee payments and automate for on time payment every time. You can even set access levels to ensure employees have only the amount of access they require. It has automatic bank reconciliation, cash flow management, inventory management, and can generate more than 400 reports. These reports aid in making correct and informed decisions so you can run your business smoothly.
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