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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 with equal market caps. One has no debt on its balance sheet, while the other one is rather debt-heavy. If you owned the latter company, you'd 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 2006. Its roughly 1.7 billion shares, at a recent stock price at the time of this writing of about $33.20, yield a market cap of around $56.4 billion. To that, we add its $11.5 billion in debt and subtract its $402 million in cash and cash equivalents. The result is $67.5 billion, a significantly higher number than the market cap.
Debt can make a big difference. If you paid $56 billion for Kraft, you would actually end up with a total bill of $67 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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Shruti Basavaraj, Adrian Rush, and LouAnn DiCosmo updated this article, which was originally written by Selena Maranjian. Neither Shruti, Adrian, nor LouAnn owns shares of Kraft. The Motley Fool has a disclosure policy.
