The enterprise value (EV) is an alternative valuation metric that reflects the market value of an entire company in a way simple market capitalization figures can't. You may have seen it described as a theoretical purchase price for an entire company because it adjusts for acquiring companies' tendency to absorb outstanding debts and pocket any available cash.
At the very least, you should understand that enterprise values generally favor companies with lots of cash and little debt. To see why this is so, let's examine enterprise value vs. market cap.
How to calculate enterprise value from balance sheet
While market cap is simply a company's stock price multiplied by the total number of shares outstanding, calculating a company's enterprise value involves some line items on the balance sheet. We start with market capitalization and add long-term debt, plus the current portion of long-term debt. We'll also need to add the book value of preferred stock and minority interest, if these less common items are present.
Now that we've made additions, we need to subtract cash and short-term investments because, in the event of an acquisition, the purchaser can simply pocket these sums. Let's look at an example from the biotechnology industry that highlights the difference. Jazz Pharmaceuticals looks like a reasonably attractive takeover target. It sports a market cap of about $6.23 billion, but a large amount of debt recently raised its enterprise value to $8.1 billion.
Celldex Therapeutics, on the other hand, has a lot of cash, and is practically debt-free. Its recent enterprise value of just $180.8 million makes it a far more attractive acquisition target than its market cap suggests.
Enterprise value to EBITDA
Dividing a company's enterprise value by earnings before interest, tax, depreciation, and amortization (EBITDA) is frequently used in place of the price-to-earnings ratio. It's an especially useful ratio when comparing debt-heavy companies in capital-intensive industries, such as automakers Ford and General Motors.
Standard trailing P/E ratios make Ford look somewhat more expensive than GM, but a look at EV to EBITDA suggests it's nearly three times as dear.
Granted, these measurements don't tell the whole story. Adding them to your toolbox, though, gives you a much better understanding of the relative values of different stocks on your radar.
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