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Enterprise Value

When an investor looks at stocks, and wants to know which is the best value, he will often use the P/E ratio—stock price divided by net earnings—to compare the different stocks. A stock with a lower P/E is often considered to be a better value, because its price is lower compared to its earnings. However, the stock price doesn’t factor in the amount of debt that a company has, and, in many cases, some companies don’t have net earnings, so they can’t be compared to other companies using the P/E ratio. Sometimes, earnings before interest and tax (EBIT) and earnings before interest, tax, depreciation, and amortization (EBITDA) are used instead of net earnings. The advantages of using EBIT and EBITDA are that firms with different capital structures can be compared. Another advantage of EBIT is that firms with different depreciation methods can be compared, and a major advantage of EBITDA is that most companies will have a positive EBITDA, so P/EBITDA ratios can be used to compare most companies. A company with a negative EBITDA would be a risky investment.

The problem with P/E ratios is that it does not account for the debt of a company or the amount of cash or near-cash equivalents on hand. For instance, if 2 companies—Company A and Company B—have the same P/E ratio and the same cash equivalents, but Company B has significantly more debt, then it will obviously be worth less than Company A. However, using enterprise value instead of price per share will more accurately reflect the true worth of a company.

Enterprise value is how much a company would cost, if you were to own it outright—free and clear. You would have to pay the price per share times the number of shares plus you would have to pay off the debt of the company, but you could subtract the cash and marketable securities owned by the company, since you would now own it, which would reduce the effective price of the company. Note that sometimes, preferred stock is added to net debt because it is much like a debt instrument.

Enterprise Value = Market Capitalization + Net Debt - (Cash + Cash Equivalents)

However, enterprise value by itself is worthless, and is, in fact, somewhat of a misnomer, because a company can have a much greater enterprise value because it has a much greater debt, which would actually lessen the value of the enterprise with all other things being equal. It should be called enterprise cost. As part of a ratio, however, it is much more informative.

Enterprise value can be used like the P/E ratio, but the EV value is substituted for the price per share in the numerator. Often, EBITDA is used instead of net earnings for the denominator, because more companies can be compared regardless of capital structure and accounting practices. Like the P/E, a lower enterprise value-to-earnings ratio is usually a better value for your investment money.

This ratio can also be reversed, with the earnings in the numerator and the enterprise value in the denominator to yield the return on investment (ROI). In other words, if you had bought the company outright and retired its debts, your ROI would be the percentage of your investments that would be returned in earned income.

Return on Investment = Earnings/Enterprise Value

This is the procedure to figure out the enterprise value:

1. From the company’s income statement, find the number of fully diluted, outstanding shares, then multiply that number by the current market price—the market capitalization.
2. From the balance sheet, find the short- and long-term debt, add them together, then add the total to the market capitalization.
3. From the current assets section of the balance sheet, subtract the cash and cash equivalents from the total, to arrive at the enterprise value.

The alternative to calculating the EV is to simply look it up. Yahoo Finance, for instance, lists both the enterprise value, Enterprise Value/Revenue, and Enterprise Value/EBITDA in the Valuation Measures section of the Key Statistics of any stock. For instance, consider Google and Wal-Mart. Believe it or not, Google has just surpassed Wal-Mart in market capitalization (October, 2007), even though Wal-Mart is a much bigger company.

By comparing ratios, you can see that Wal-Mart has better fundamentals, and is a better value, according to almost any ratio. Of course, investors expect Google to continue growing at a phenomenal rate, which is why they priced its stock so high, but, as much as I like Google, it simply cannot last. As with all fast-growing companies, growth will have to slow as the company grows larger—it is the nature of the beast. Investing in Google now would be very risky. As you can see from the above table, the market cap difference between Google and Wal-Mart is $32.21 billion, a very substantial difference. A 32 billion dollar company in itself would be a very big company. But I digress.

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