Enterprise Value Explained

Enterprise value represents a company's economic value -- the minimum 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 price tag for a company. That's true, but market cap ignores debt, and with some companies debt is substantial and changes the picture significantly. Enterprise value is a modification of market cap, incorporating debt.

To understand the concept of enterprise value better, 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 X total shares outstanding

Debt = long-term debt + short-term debt

Enterprise value = market capitalization - cash and equivalents + debt

Let's examine the Walt Disney Co. (NYSE: DIS  ) , using its quarterly earnings report for the quarter ended in March 2004. Its 2.11 billion shares at a recent stock price of $23 yield a market cap of around $49 billion. To that we add its $15.3 billion in debt and subtract its $3.1 billion in cash and cash equivalents. The result is $61.2 billion, a significantly higher number than the market cap.

Debt can make a big difference. If you paid $49 billion for Disney, you would actually end up with a total bill of $61.2 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.

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