Foolish Fundamentals: Enterprise Value

Enterprise value (EV) represents a company's economic value -- the minimum amount someone would have to pay to buy it outright. It's an important number to consider when you're valuing a stock.

You may remember that market capitalization (the current stock price multiplied by the number of shares outstanding) also serves as a company's price tag. But market cap ignores debt, and with some companies, debt is substantial enough to change the picture significantly. Enterprise value, on the other hand, is a modification of market cap that incorporates debt.

To better understand the concept of enterprise value, imagine that you're looking at two companies that have equal market caps. One has no debt on its balance sheet, while the other one is rather debt-heavy. Whoever owns the latter company will be stuck making lots of interest payments over the years -- so you probably wouldn't pay the same price for each company.

By the same token, imagine that you have two companies with equal market caps of $50 billion and no debt. One has negligible cash and cash equivalents on hand, and the other has $5 billion in cash in its coffers. If you bought the first company for $50 billion, you'd have a company worth, presumably, $50 billion. But if you bought the second company for $50 billion, it would have cost you just $45 billion, since you instantly have $5 billion in cash. These are the kinds of things enterprise value takes into account.

To calculate enterprise value, start with a company's market cap, add debt (found on a company's balance sheet), and subtract cash and investments (also on the balance sheet). To get total debt, add together long- and short-term debt.

  • Market cap = current share price * total shares outstanding
  • Debt = long-term debt + short-term debt
  • Enterprise value = market capitalization - cash and equivalents + debt

Let's examine Motley Fool Income Investor recommendation Kraft Foods (NYSE: KFT  ) , using its quarterly earnings report for the quarter ended in June 2005. Its roughly 1.7 billion shares, at a recent stock price at the time of this writing of about $28.52, yield a market cap of around $48 billion. To that, we add its $11.1 billion in debt and subtract its $396 million in cash and cash equivalents. The result is $59.2 billion, a significantly higher number than the market cap.

Debt can make a big difference. If you paid $48 billion for Kraft, you would actually end up with a total bill of $59 billion, because the company comes with a lot of debt. The enterprise value reminds all investors, large and small, that debt is a cost to the business.

Shifting from the concept of corporate debt to personal debt, are you overloaded with borrowings? Learn more in our Credit Center.

And by the way, if thinking about investing makes your head hurt and you'd like an actual person (a financial pro, no less) to talk with about your financial situation, look into our TMF Money Advisor. It's a valuable service that features customized independent advice from a variety of objective financial experts. You need to make sure you're saving enough, and well enough, to meet all your needs. (To take savings matters into your own hands, visit our Savings Center.)

Selena Maranjian, Shruti Basavaraj, and Adrian Rush contributed to this article.

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 14, 2011, at 7:56 PM, prginww wrote:

    The comment "The enterprise value reminds all investors, large and small, that debt is a cost to the business" really misses the point. Debt is a form of capitalization. If a company needs money to grow or expand, it can go to the equity markets and issue stock, or it can go to the debt markets and issue bonds. Both investors demand a return, equity investors in the form of dividends or stock price appreciation, and debt investors typically in the form of interest payments. The big difference is that debt investors have a more powerful recourse if they don't get a return; they can make a direct claim on company assets and potentially force the company into bankruptcy. Equity investors can generally only sell their stock.

    Debt has the beneficial affects of a tax shield on a companies earnings. Debt also leverages the return (and the risk) of the equity investors. There are valid financial reasons why most large corporations take on debt, and this article doesn't even allude to those reasons. The digression into advertising their financial services at the end of the article severely reduces the professionalism and credibility of the whole article.

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