A topic I want to cover is "enterprise value," which has confused quite a few Fools the country o'er.
Enterprise value is a measure of the actual economic value of a company at any given moment. Enterprise value measures what it would actually cost to purchase the entire company. Many investors use the current value of all of a company's outstanding shares as a proxy for its economic value. Known as market capitalization, the current market value of all of a company's shares is equal to the current number of outstanding shares multiplied by the current share price:
Market Capitalization = Number of Shares Out * Current Share Price
You can find the current share price almost anywhere, thanks to the wonder of 15-minute delayed and real-time quotes. Shares outstanding can be a little trickier, but truth be told I only use one source to find this number -- the latest quarterly earnings press release or SEC filing. Although the number appears in the quote feeds of a number of data providers, I have found that it often lags the latest reported quarter by a couple of weeks and seldom takes into account in timely fashion the shares issued to acquire another company.
Now, if market capitalization is the value of all of the outstanding shares, why use enterprise value at all? I mean, enterprise value only appears in a few business school textbooks that focus on cash-flow valuations. The rest of the investment media uses market capitalization. Well, let me let you in on a little secret. Wall Street is many things, but it is not thorough and it is not scientific. In fact, it is downright scary when you look hard enough and see that there is really no unified body of knowledge outside of the quite excellent Chartered Financial Analysts program (which has only about 40,000 graduates total ever) that analysts, market strategists, and pundits draw from. Carpentry (a quite noble profession) has a more rigorous set of intellectual standards.
Although market capitalization is the key component of the actual economic value of a company, it is hardly the only one. Using only market capitalization to value companies is kind of like using the down payment on a house as a proxy for how much a house is worth. The larger the mortgage on the house is, the more wrong you end up being. When a company carries long-term debt, which is essentially what a mortgage is, the company has pledged its own assets to borrow money. If someone were to acquire that company, she would also acquire responsibility for that debt. Much like the person who "assumes" a mortgage of $50,000 after paying $20,000 in equity for a home, a company that pays $20 million for the stock of a company with $50 million in debt has really paid $70 million for the entire company.
The simple fact is that debt matters. Now, many companies have an inconsequential amount of debt; however, there are plenty where the amount of debt that the company has is quite consequential. A controversial, Nobel prize winning economic theory called M&M (after two professors named Modigliani and Miller) proposed that the effective capital structure of a company was the market value of its equity plus its debt. The controversial part was when they went on to say that there is no optimum capital structure, meaning that every dollar of debt a company carried consumed a potential dollar of equity. Put another way, a company's value was a given. Whether it chose to recognize that value all in debt or equity was the company's choice -- there was no capital structure that resulted in a higher valuation without increasing earnings somehow.
Another very important factor to consider when analyzing a company is what it has in the bank. If a company has a hoard of cash or significant equity stakes in other publicly traded businesses, these are pretty easy to value and are obviously sources of liquidity for the company. Going back to our home example, say you bought a home for $70,000 -- $20,000 in cash and $50,000 in debt after assuming the mortgage. When you walked in the house, you found $20,000 in cash left by the previous owner. After putting this $20,000 in the bank, your effective purchase price becomes $50,000. Although you paid out $20,000 to the owner, you got it right back.
Because of the rather complicated rules of acquisition and corporate ownership, this somewhat ludicrous example happens all of the time in the business world. If a company has $20 million in cash in the bank, it is not like the outgoing Chairman can put it in his pocket as he leaves. That money belongs to the company -- and those who own the company. If someone is buying the company, that money really belongs to him or her. No one else can take it. As a result, when the old owners are paid off they are paid off with cash from the new owners -- leaving any cash in the company behind for the new owners to keep. Given that equity stakes in other publicly traded companies are really just as good as cash -- heck, maybe even better -- it makes sense to count this as part of the cash hoard for the purposes of determining what the actual economic price of a company is.
Given all of this, you can see that the real, economic purchase price of a company at any given moment is the value of the stock (the market capitalization), plus the debt that the company has taken on, minus any cash or investments it has on the books. This is what we call enterprise value. We use this instead of market capitalization because it is the actual economic purchase price of a company at any given moment. Enterprise value reflects the actual purchase price anyone acquiring a company would have to pay.
Enterprise Value = Market Capitalization + Long-term Debt - Cash & Investments
Why go to all of this trouble when some people argue that the value of the stock has already been adjusted for the debt and cash a company has? Because no matter how much the actual price of the stock changes, the debt and the cash do not go away. An acquirer still has to take on the debt and still gets to put the cash in the bank whether the company's stock is worth $1 billion or one dollar. Debt and cash are economic realities and must be factored into the purchase price an acquirer pays for a company. Enterprise value is not a valuation, meaning the theoretical price at which a company should trade, but a value, meaning the current, real price as definite as if stuck on with a pricing gun.
Randy Befumo is a former Fool writer currently working in the investment industry. This column first appeared on the Fool in 1997.