Most investors only care about a company's market capitalization. But sometimes a company's market cap doesn't tell the whole story as it doesn't reveal its total size. This can leave investors dangerously exposed to a company's debt, which could be looming below the horizon. That's why investors really need to take a closer look at a company's total enterprise value, or TEV, because it provides investors a full picture of a company's capital structure. That picture sometimes shows that the company is weighted down by a dangerous pile of debt or that the company's valuation isn't as expensive as it appears when looking at only its market cap.
Calculating a company's TEV is pretty easy as investors just need to pull up its latest balance sheet. The formula is simply: TEV = Market Capitalization + Debt + Preferred Stock-Cash and Equivalents.
What this really tells investors is how much debt a company has in its capital structure. It also gives us an idea of what it would cost a buyer to acquire the company. Further, once we have a company's TEV we can use it to run a number of calculations that provide a more accurate picture of a company's valuation, financial health, and returns.
Using TEV to see below the surface
Many companies use debt to fund their growth, however, some use a lot more of it than others. This can actually hide the true size of an entity. We see this by comparing the market capitalizations to the enterprise values of three well-known companies: General Motors (NYSE: GM), Freeport-McMoRan (NYSE: FCX), and Exelon (NYSE: EXC). Here's a look at the market caps.
By market caps all three companies look big, but not huge. However, when we add in the debt these companies carry as part of their TEV we see that these companies are a lot bigger than the market cap indicated.
Note that all three companies are carrying in excess of $20 billion in debt and/or preferred equity, which bolsters their TEVs to be substantially higher than the current market cap. This means a would-be buyer would really have to put up a lot of money to buy out one of these companies.
Using TEV to get a better valuation multiple
The other important reason to look at a company's TEV is because it can help to normalize a company's valuation. We see a great example of this by comparing two of America's top independent oil companies, ConocoPhillips (NYSE:COP) and EOG Resources (NYSE:EOG).
A common valuation multiple used by most investors is the Price-to-Earnings ratio, or P/E ratio. For the most part it's a solid ratio to use, but sometimes it doesn't tell the whole story as it only factors in the market cap. Because of this it can make a stock look expensive relative to a close peer when in fact it's not as expensive. For example, if we take a look at the P/E ratios of ConocoPhillips and EOG Resources it would seem that EOG is much more expensive.
However, if we factor in the TEV of these two oil giants we find that ConocoPhillips uses a bit more debt. In fact, its equity market cap as a percentage of its TEV is about 80% equity while EOG Resources' is about 91% equity as debt makes up a lower percentage of its enterprise value. We can then normalize for this by using an EBITDA-to-Enterprise Value, which is similar to the P/E Ratio, but looks at underlying cash flow generation and factors in debt. Here's what we find by switching to a valuation based on TEV:
As we can see, the valuations are nearly identical. This suggests that EOG Resources isn't quite as expensive, which is why it can pay to look at the whole picture.
By looking at a company's TEV we get to see the whole picture of a company's value. In a sense the TEV is what a buyer would need in order to buy the entire company. Further, the TEV enables investors to use a better valuation metric, which factors in debt and can tell a completely different story a valuation metric that looks at market cap alone.
Matt DiLallo owns shares of ConocoPhillips. The Motley Fool recommends General Motors. The Motley Fool owns shares of EOG Resources, and Freeport-McMoRan Copper & Gold,. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.