A Tale of Two Total Stock Values: Enterprise Value vs. Market Cap

Market caps aren't the only way to measure the size of a stock. Enterprise value is in many ways a more fair measure, but it gets far less attention than the simple market cap.

Let's change that.

The market cap is a simple calculation. Find a recent share price, multiply that by the total number of shares outstanding, and Bob's your uncle. The two data points you need are easily found, the math is trivial, and the resulting figure is easy to understand. It's no wonder why so many investors never look beyond the simple market cap.

But the cap is just a starting point for enterprise value calculations. It's the market cap, minus cash on hand, plus debt balances. Heavy debt makes the value go up, while extra cash brings enterprise value down.

If that seems backward, think of the stock as a wallet for sale with either cash or IOU stubs tucked inside. Buying a wallet with free cash included works out to a discount for you, and vice versa. The enterprise value is what a hypothetical buyer would pay for the entire company, cash reserves and debt papers included.

Some stocks come with large market caps but smaller enterprise values, based on their positive net cash balances. Others turn that equation upside-down. Let's find some examples of each from the Dow Jones Industrial Average (DJINDICES: ^DJI  ) .

Company

Market Cap (billions)

Enterprise Value (billions)

EV/Cap Ratio

Verizon (NYSE: VZ  )

$134

$235

1.75

Caterpillar (NYSE: CAT  )

$54

$90

1.66

Microsoft (NASDAQ: MSFT  )

$280

$220

0.79

Cisco Systems (NASDAQ: CSCO  )

$125

$91

0.73

Source: S&P Capital IQ. Figures current as of Oct. 2, 2013.

These are the Dow stocks with the largest imbalance between market cap and enterprise value. I'm not counting the financial powerhouses because their capital-intensive business models don't lend themselves to enterprise value discussions. Other than the four bank-like Dow stocks, the tickers above represent the heaviest and the lightest net debt balances on the index.
 
Verizon borrowed heavily to build its nationwide phone and data networks, both wired and wireless. The company is still saddled with $47 billion of that debt and less than $2 bilion in cash for day-to-day operations. This is a common model in the telecom industry, and anywhere else where you have to spend a ton of cash to build the basic business platform.

Caterpillar is another example of capital-heavy operations. Its $36 billion in debt is balanced by just $4 billion in cash. Factories capable of making heavy construction machinery don't come cheap, and Caterpillar's expensive inventory also weighs on the balance sheet. The company typically sits on roughly $15 billion of unsold or unfinished machines, but the parts already had to be paid for.

These two stocks show how market caps sometime undervalue the actual company. Verizon's miles of copper cable and optical fiber are an essential part of the business model, as are Caterpillar's work-in-progress inventories. And it's unfair to forget about the debt they carry to keep the wheels turning. That's why these stocks are worth more -- certainly to a potential buyout baron but also to informed investors of every stripe -- than their market caps would tell you.

The flip side
The same argument holds true on the flip side of the coin. Microsoft runs a very lean business model with gross margins north of 70%, based more on software licenses than on shipping physical products. Cisco Systems sports 60% gross margins because its hardware is the undisputed king of the networking market, with all the pricing power stability that follows.

These guys have no need for expensive factories or cable runs. Even Cisco outsources most of the actual manufacturing work to third parties. So Cisco presides over negative $34 billion in net debt thanks to its rich cash flows and minimal capital needs, and Microsoft's $60 billion net cash pile is nearly twice as large for the same reasons.

Nobody expects Cisco or Microsoft to be acquired anytime soon. Their cash balance discounts offer something like a 20% discount to their plain market caps, but we're still looking at takeout bills of epic proportions. I would still encourage you to take a second look at their balance sheets when setting a target price or sketching up an investing thesis.

If nothing else, these huge imbalances could mean that Cisco and Microsoft should try harder to return value to their investors. Buybacks and dividends generally don't move market caps around, but they do reduce cash reserves and hike up enterprise values. Most Dow stocks have larger enterprise values than market caps. Perhaps the tech giants should strive to join that club.

What it all boils down to
In the end, market caps and enterprise values are nothing more than measuring tools. The best investing approach swerves away from nitpicky valuations and prefers to choose great companies and stick with them for the long term. The Motley Fool's free report "
3 Stocks That Will Help You Retire Rich" names stocks that could help you build long-term wealth and retire well, along with some winning wealth-building strategies that every investor should be aware of. Click here now to keep reading.


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