January 11, 2018
One of the important components of valuation is market capitalization (Mcap) that values the stocks of a company. It is calculated as the share price multiplied by the number of shares a company has outstanding.
Example: If a company has 10 shares and each sells at Rs100, the market capitalization is Rs1,000. This is required to be paid to buy every share of the company. Thereby, it gives more of the price than the value of the company.
In comparison to the market capitalization, on the other hand, modification of market cap that includes debt and cash for valuing a company is defined as the Enterprise Value (EV) or Total Enterprise Value (TEV) or Firm Value (FV). In other words, a more comprehensive, alternative and accurate representation compared to Mcap is the EV, that helps measure the company’s total value. Simply put it is the minimum that someone would pay to buy a company outright.
Enterprise value is calculated as the market capitalization plus debt, minority interest and preferred shares, minus total cash and cash equivalents.
Market capitalization = value of the common shares of the company
Preferred shares = If they are redeemable then they are treated as debt
Debt = All inclusive of bank loans, bonds which are to be dealt by the acquirer
Minority Interest = It is defined as the portion of subsidiaries that is held by the minority shareholders.
Cash and Investments = Highly liquid investments, cash in hand, cash at bank are considered
In the above formula, as the acquirer would be liable for the debts of a company, debt increases the cost of purchasing a company and is, therefore, an addition in the EV calculation formula. On the other hand, cash would be an asset, so it is a subtracted in the EV calculation.
Debt and cash have a strong impact on a company’s EV. For example, two companies with the same market capitalizations would have different enterprise values. A company with a Rs500cr market capitalization, no debt, and Rs10cr in cash would be cheaper to acquire than the B company with same Rs500cr market capitalization, Rs30cr of debt and no cash.
The first step after acquiring a company is to extract all the existing cash or assets which are not necessary to run the business. Once that is done, the acquirer will then put as much debt onto the target company ’s balance sheet and let it pay out as a dividend or capital reduction. The more the acquirer can get out quickly either as excess cash or as a dividend recap i.e. debt-financed dividend, the higher the return on investment (ROI).
The below mentioned example is the calculation of the enterprise value of Navneet Education Limited. The different components required for calculating EV are separately done and then inserted in the formula.
Source: Annual Reportort
EV / EBIDTA
where EBITDA is = recurring earnings from continuing operations + interest + taxes + depreciation + amortization
EV / Sales
It is a preferred ratio to Price / Sales as it accounts for the debt component to be paid back. Lower the EV / Sales ratio, more attractive or undervalued the company is.
Any kind of investments whether in stocks or a particular company as a whole would need detailed information on the fundamentals of the company, its comparison with the peers and this can be done with the help of EV calculations. The enterprise multiple gives an indication of how expensive or cheap a stock is based on the past and expected cash flows. It helps the investor to take appropriate decisions considering the market capitalization along-with the debt and cash positioning of the company. However, one must note that enterprise multiple is also not always foolproof as a cheaper stock could take the beatings of negative market sentiments.