What it is:
Enterprise value represents the entire economic value of a company. More specifically, it is a measure of the theoretical takeover price that an investor would have to pay in order to acquire a particular firm.
How it works (Example):
Enterprise value is calculated as follows:
Some analysts adjust the debt portion of this formula to include preferred stock; they may also adjust the cash portion of the formula to include various cash equivalents such as current accounts receivable and liquid inventory.
For example, let's assume Company XYZ has the following characteristics:
Shares Outstanding: 1,000,000
Current Share Price: $5
Total Debt: $1,000,000
Total Cash: $500,000
Based on the formula above, we can calculate Company XYZ's enterprise value as follows:
($1,000,000 x $5) + $1,000,000 - $500,000 = $5,500,000
[InvestingAnswers Feature: Financial Statement Analysis For Beginners]
Why it Matters:
When attempting to gauge the overall value Wall Street has assigned to a firm, investors often look exclusively at market capitalization (calculated by multiplying the number of outstanding shares by the current share price). However, in most cases this is not an accurate reflection of a company's true value.
Enterprise value considers much more than just the value of a company's outstanding equity. To buy a company outright, an acquirer would have to assume the acquired company's debt, though it would also receive all of the acquired company's cash. Acquiring the debt increases the cost to buy the company, but acquiring the cash reduces the cost of acquiring the company.
Debt and cash can have an enormous impact on a particular company's enterprise value. For this reason, two companies with the same market capitalizations may sport very different enterprise values. For example, a company with a $50 million market capitalization, no debt, and $10 million in cash would be cheaper to acquire than the same $50 million company with $30 million of debt and no cash.
The P/E ratio and other formulas commonly used to measure value don't typically take cash and debt into consideration. For this reason, it's sometimes called the "flawed P/E ratio." To get a better sense for a company's true valuation, many analysts and investors prefer to compare earnings, sales, and other measures to enterprise value.