What is Enterprise Value for Private Company and how investors use it for their purpose?
Enterprise value calculation is one of the ways to value a company.
People often ponder about how to value a company.
Enterprise value provides quick answer. Calculating enterprise value is easy.
Value of market capitalisation is easily available online. We can use market cap to calculate enterprise value.
Market capitalisation is a value that tell us how much a company is valued by market. But this value in isolation can be misleading.
A more realistic valuation can be obtained from Enterprise Value calculation.
Even enterprise value cannot considered as true value of a company for the following reasons:
- While calculating enterprise value companies income generating capabilities are not considered.
- Companies asset base is also not analysed.
But this is also a fact that, enterprise value is more reliable indicator of stocks true value than market capitalisation.
How this value helps the investors?
From concept point of view, Enterprise value of private company is that minimum cost which must to paid to “own 100% shares of company“.
#1. Market Capitalisation & Debt of Company
Suppose I want to sell my Company A.
For a layman, the cost that one should pay to buy all shares of Company A is equal to its “market capitalisation”.
But this is not the right price at which the company A must be purchased. Why?
To know this, one must know how market capitalisation is calculated.
Market capitalisation is, current market price multiplied by the number of shares outstanding in market.
Suppose market capitalisation of my Company A is Rs.30000 Crore.
To takeover A, one can pay me Rs 30,000 crore and take control of A.
But this will be a mistake of the Buyer. I will gain, but buyer may lose this way. How?
Because, further to Rs.30,000 Crore payment, the buyer may still incur more costs related to A’s 100% acquisition.
Suppose at the time of sale, my Company A was carrying a debt of Rs 1,000 Crore.
After takeover of A, these Rs 1,000 Crore will become the buyers liability.
So, even though he has already paid Rs 30,000 Crore, but he will further need to pay Rs 1,000 crore to the lenders of “A”.
In this case the cost of the buyer will increase (Rs 30,000+1,000=Rs 31,000 Crore).
This is like a loss to the buyer.
Had the buyer paid only Rs.29,000 Crore to me, considering “A” has a debt of Rs.1,000 crore, it would have been the true valuation of the company.
Just to sum it up, what is Rs.29,000?
Rs.29,000 Crore is the price paid the buyer to acquire 100% stake in “A”.
Why Rs.29,000 Crore and not Rs.30,000 Crore?
Because in future, the buyer will face an additional cost of Rs.1,000 crore to payoff all the current debts of “A”.
This way, the total effective cost of the buyer will not overshoot.
The total effective cost to the buyer will Rs.30,000 (29,000 paid to present owner + Rs.1,000 paid to lenders).
This is important. Upfront, the buyer must pay only Rs.29,000 crore to the present owner of “A”.
From where comes this realisation that one must also consider debt levels while calculating true value?
The answer is hidden in the Enterprise Value Formula.
#2. What is Enterprise Value Formula?
Estimating true value of any company by using enterprise value formula, will help the user to arrive at a more logical conclusion.
In order to own 100% ownership of any listed company (forget about SEBI rules now), investor will need to buy its shares at market price.
This is what a company is valued as per its market capitalisation(Market Price x Number of shares outstanding).
After one owns the company, company’s debt acquired by the previous owner must also be paid.
But this is not the end. There is one more step. We will also come across companies Cash.
Suppose, the company “A” had some “cash & cash equivalent”. Lets call it as “Cash” from this point forward.
[Note: Cash is visible in companies balance sheet. Hence it cannot be hidden from the buyer.]
When the buyer buys “A”, these cash reserves are also at his disposal.
This is like liquid money available for use by the buyer.
But this liquid cash will come for free. The buyer will have to pay for it, over and above the market capitalisation.
Lets taken a hypothetical example for clear understanding.
#2.1 Example2 – Company “A”
- Market Cap: Rs.30,000 Crore.
- Debt: Rs.1,000 Crore.
- Cash: Rs.500 Crore.
What is the enterprise value of Company “A”?
How much the buyer should pay to the current owner to own 100% stake in “A”?
Lets use the enterprise value formula to answer these 2 questions:
The enterprise value of the “A” is Rs.30,500.
The buyer should pay Rs.29,500 to current owner. Why?
Buyer pays only Rs.29,500 to ensure that he does not overspend.
The total cash-out of the buyer must be equal to the Market Capitalisation. In this cash, the buyer is not overspending.
Lets see what are the cash-outs for the buyer during purchase of “A”
- 29,500 Crore – Payment made to current buyer.
- 1,000 Crore – Payment made to lender to pay-off debt of “A”.
- -Rs.500 Crore – Available cash of “A” used by the buyer.
- Total cash out = 29,500+1,000-500 = Rs.30,000 Crore.
#2.2 Example2 – Company “B”
- Market Cap: Rs.30,000 Crore.
- Debt: Rs.500 Crore.
- Cash: Rs.600 Crore.
What is the enterprise value of Company “B”?
How much the buyer should pay to the current owner to own 100% stake in “B”?
Lets use the enterprise value formula again.
Enterprise value = Market Cap+Debt-Cash.
Enterprise value = 30,000+500-600 = Rs.29,500 Crore.
Payment to made to current owner = Market Cap-Debt+Cash.
Payment to be made = 30,000-500+600 = Rs.30,100.
Lets see what are the cash-outs for the buyer during purchase of “B”
- 30,100 Crore – Payment made to current buyer.
- 500 Crore – Payment made to lender to pay-off debt of “B”.
- -Rs.600 Crore – Available cash of “B” used by the buyer.
- Total cash out = 30,100+500-600 = Rs.30,000 Crore.
#3. Explaining Enterprise Value Formula
Let’s look into the individual components of calculating enterprise value.
A short explanation of the individual components will help to get further clarity on the subject.
There are mainly 3 main components of enterprise value:
- Market capitalization
Lets see what each component mean, and how they help in estimating the true value.
#3.1 Market Capitalisation:
If one wants to know the value of company with only on click of a button, then market capitalisation is that number.
Though it may not represent the ‘true value’ of company.
It only gives an approximate idea about companies true worth.
Generally speaking, for a company which is doing good business, market capitalisation numbers often value company on the higher side.
The true value of such a company will be less than its market capitalisation numbers.
How to calculate market cap?
Number of share x Market price.
In addition to market capitalisation, the buyer needs to pay-off the debt as well.
So if a company is acquired at market cap of Rs.30,000 crore, and it also owes a debt of Rs.1,000 crore, then total cost of acquiring the company will be Rs.31,000core.
But it should not be like this.
Market capitalisation is that value of the company which factors in all if’s and but’s of a company.
A buyer must take extra care to ensure that payment made to acquire the company is more than its market capitalisation.
Hence debt component in the enterprise value formula, makes the buyer aware of this future liability.
#3.3 Cash and Cash Equivalents:
“Cash and Cash Equivalents” can also be obtained from the companies balance sheets.
The cash and cash equivalents are measure of liquid capital that company uses to manages day to day expenses of company.
Ideally all companies should maintain a positive value of cash in their current account.
This means that, even after paying all of its liabilities (vendor payment, interest on loans etc) companies has enough cash left in its current account.
This depicts a good financial health of company.
How a buyer can utilise the cash of company he has acquired recently?
This leftover cash can be used by the buyer to pay part of the acquired debts of company.
For value investors, a company that is maintaining high liquid cash and low debt levels is of great interest.
Value investors will always like to link cash and debt with companies true value.
Hence, in order to value a company accurately enterprise value formula is a good tool.
Enterprise values formula rates companies higher in following conditions:
- If a company is popular among investors (high market cap).
- Carries low debt &
- Enjoys high liquid-cash.
Enterprise Valuation of Top Companies in India
(Updated on April’2018)
- Reliance Industries Ltd.
- Tata Consultancy Services Ltd.
- HDFC Bank Ltd.
- ITC Ltd.
- Housing Development Finance Corpn. Ltd.
- Hindustan Unilever Ltd.
- Maruti Suzuki India Ltd.
- Infosys Ltd.
- Oil & Natural Gas Corpn. Ltd.
- State Bank of India
Check this link to get a list of Top 50 Indian stocks with their Market Cap and Enterprise value, P/E ratio, Price in tabulated form…