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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 is rather debt-heavy. If you owned the latter company, you'd be stuck paying off that debt eventually, while making lots of interest payments over the years. So you'd probably pay less up front for the company with debt.
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, your net cost would be only $45 billion, since the company came with $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 times 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 earnings report for the quarter ended in June. Its roughly 1.6 billion shares, at a recent stock price of about $32, yield a market cap of around $51.2 billion. To that, we add its $12.5 billion in debt and subtract its $419 million in cash and cash equivalents. The result is $63.3 billion, a significantly higher number than the market cap.
As you can see, debt can make a big difference. If you paid $51.2 billion for Kraft, you would actually end up with a total bill of $63.7 billion before adjusting for cash, 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.
