When looking to make an investment in a new business, there are many different metrics that you need to take into consideration to determine whether you are getting a good deal or not. One metric that needs to be taken into consideration is the enterprise value of the business. You can determine this by using the enterprise value formula.
The enterprise value of the business is typically considered the most efficient way of determining what the true cost of a business acquisition is. This article will explain what an enterprise value is. You will also learn how to calculate enterprise value. Then, you can see how to apply it when trying to make a business decision.
What Is the Enterprise Value?
The enterprise value of a business is the ultimate value of an organization. When you are looking to acquire a business, simply checking the current market capitalization of the business may not be enough. Looking at a business in this method does not necessarily account for additional cost. Also, there are others that you will take on as a result of buying the business.
The enterprise value will take all of these factors into consideration and will provide you with:
- A true value;
- Cost of acquiring a company.
How to Calculate the Enterprise Value
- When you are looking to calculate the overall value of a company upon acquisition, the first thing that you must follow is the enterprise value formula. The enterprise value formula is relatively simple to follow. To calculate the enterprise value of a company, the first thing that you must do is figure out the value of the common stock. To do this, you need to take the current market price of the stock. Then, multiply it by all of the shares outstanding. This will give you the current market capitalization of the company.
- Once you have the overall market capitalization, take the next step. This is to add back all of the outstanding debt and preferred equity. When you take over a company, you will be responsible for all of the current loans outstanding. You are also responsible for paying off preferred equity. Because of this, the cost must be add to the base market capitalization.
- The third part of the enterprise value formula is to back out liquid assets. This means that you should look at the current balance sheet of the company that you are buying. Then, reduce the value of the company by cash and liquid investments. You are doing this because this will be an easily liquidated asset that you will receive when you close on the purchase of the company. It effectively will automatically reduce the gross purchase price.
Determine the True Cost of Buying a Company
There are several different advantages that come one you calculate the enterprise value of a company in base your purchase decision off of this.
The main advantage is that this will show the true cost of what you are buying. The market capitalization will show the current gross equity up a company. However, it does not necessarily take into consideration all of the liabilities and accrued cost that you will have to take on when you take over the company.
Enterprise Value Formula as a Comparative Tool
After you have calculated the enterprise value formula, it is important that you use it as a tool to compare it to other businesses. One of the best ways to use enterprise value to your advantage is to compare it to the current capital of the business that you are analyzing. When doing this, you should take the current value that you calculated and divided by the trailing twelve-month EBITDA of the company. This will give you an EBITDA multiple.
Once you have done this, you can then compare the resulting multiple to other companies. Ideally, you should compare it to other companies that are in similar industries or are in similar life cycles in the business plan. This can give you a glimpse as to whether you are buying a company at a good price as compared to the current cash flow.
Downsides to the Enterprise Value Formula
There are clear advantages that come with using the enterprise value formula to determine the value of the company and to compare it to other potential acquisition opportunities. However, there are some disadvantages as well.
- One of the main drawbacks of using the multiple and formula is that it does not necessarily properly capture businesses that are in a period of growth. For example, if a business is growing it could have received an influx of working capital. Consequently, this could actually inflate its cash flow. If you use this inflated amount to calculate the multiple, it could end up overvaluing the underlying assets and business.
- Another way that you may not get a clear picture of the current value of a business if you use the formula and multiple is if it does not accurately account for capital expenditures. Let’s say that a business has spent a lot of money on capital expenditures in recent years. This could reduce its cash flow. However, the capital expenditure investments could actually be a value creator. This means that there is a chance that you will end up undervaluing a company. You will do this just because it has spent money on investments in the business.
To Sum It Up
In conclusion, when you are looking to make an investment in a company, it is important that you properly value the company. One of the best ways that you can value a company today is by using the enterprise value formula.
This formula will be able to provide you with the true cost of the company. Of course, you will see this after factoring other constant that that you will have to pay once you are the owner.
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