When an investor wants to value a business, they look at EV or Enterprise Value. In layman terms, EV is the amount which a person is willing to pay for a business or value of a firm in the eyes of an investor.
How do you calculate EV?
First let's look at the short version of the formula, EV = Market Cap + Total Debt - Cash. The formula can be further expanded into EV = Market Cap + Preferred Equity + Minority Interest + Total Debt - Cash
The formula represents the value of equity and the value of debt minus cash.
Let us try and understand the formula now, what are the components of equity? Equity includes both common and preferred equity
Why do we add minority interest? While consolidating operations of subsidiaries 100% of subsidiaries sales are added to parent's while the parent might own only 80% stock in the subsidiary and the remaining 20% is represented by minority interest. So to value a company correctly minority interest is added.
Total debt represents the market value of debt and cash is subtracted because when a company is acquired cash is also transferred to the incoming investor along with other assets so it is only logical that when you pay $100 million for an asset and get back $10 million in cash, the effective value is $90 million.
EV can also be calculated using free cash flows to the firm (DCF approach) and using relative valuation multiples (EV/Sales, EV/EBITDA, EV/FCF)
Can EV be negative or zero?
The answer is YES. It almost seems unimaginable that EV can be negative. Let me try to justify a negative EV value, when a company's cash exceeds its equity and debt value the EV is negative. Essentially the business is paying to buy itself. Negative EV values are representative of an undervalued stock.
For example, A company with a share price of $2 and shares outstanding 100 million has an equity value of $200 million. Let's assume the company has no debt and preferred equity and the cash on books is $250 million. EV in the given case is ($50) million. You can purchase all equity shares of the company for $200 million and be entitled to $250 million of cash along with other assets, such a bargain.
Some critical valuation ratios explained:
EV/Sales: The ratio helps to calculate the value an investor is willing to pay to acquire the sales of a company.
Investors usually take the EV/Sales of comparable companies and arrive at a median value to apply to the sales of the company they want to be valued. A lower EV/Sales represents that a company may be undervalued and vice versa.
EV/Sales is considered a better measure of valuation than P/Sales because it takes into account the value of debt. The income generated from sales is used to service both debt and equity and hence the superiority.
EV/EBITDA: It represents the payback period to acquire the company. For example, if the EV/EBITDA of a company is 6, it will take 6 years for the company to pay back its value to the investor through EBITDA.
EV/EBITDA is considered a better measure of valuation than EV/Sales since it takes into account the cash costs associated with the operations of a company. A major goal of any company along with growth is increasing profitability in the long run and while sales are a good measure of growth, the thing that remains most important at the end of the day is THE BOTTOM LINE.
Why we compare EV and EBITDA and not EV and net income? The simple reason is while the enterprise value represents the value of the firm, net income is the share of only equity shareholders to the profits of the firm. To compare apples to apples, we use EBITDA rather than net income. The EBITDA is often substituted by EBIT but EV/EBITDA remains a widely used valuation metric.