How to Use Enterprise Value as an Valuable Investment Tool

If you don't already use enterprise value to help you value stocks, you might want to add it to your investment tool box. Enterprise value can add critical information to your investment research that is not provided by other analytic tools.

Enterprise value is an estimate, at a point in time, of the market value of a company's total business. It is calculated by adding a company's total outstanding debt (including interest-paying convertible debt), minority interest, and preferred stock to its market capitalization and then deducting its cash and cash equivalents outstanding. This figure is one measure of what it would cost to purchase the entire business, since an acquirer would not only have to buy the company's outstanding shares but would also be responsible for repaying any debt outstanding and would be able to reduce the purchase price by netting cash on hand against it.

A company's actual buyout value may be different than enterprise value. For example, shareholders might be unwilling to sell their shares except at a premium to the current share price.

The enterprise value ratios most often used to compare companies are enterprise value divided by earnings before interest and taxes (EBIT) or enterprise value divided by earnings before interest, taxes, depreciation and amortization (EBITDA). As with the more widely used price-to-earnings ratio, the lower the enterprise value-to-EBIT (or EBITDA) ratio, the more attractive a company's value (all other things being equal).

Enterprise value can be a valuable investment tool. In particular, it can be useful when comparing companies with different capital structures. Obviously two companies can have the same market capitalization and very different enterprise values if one has substantial debt and very little cash on hand and the other has little or no debt and/or substantial cash on hand.

As with most stock valuation measures, the enterprise value ratio shouldn't be the only valuation measure used when evaluating a company. However, it can add valuable information to your investment analysis that is not provided by other analytic tools. In addition, along with other valuation measures such as price-to-earnings, price-to-book value per share, and market capitalization-to-revenue, it can result in a more complete valuation overview and, therefore, better decision making.

Sources:

www.investopedia.com, Enterprise Value (EV)

Ben McClure, www.investopedia.com/articles/fundamental, EV Gets Into Gear