Valuing target companies is a critical part of M&A transactions. The two most commonly used metrics for this purpose are enterprise value and market capitalization. If your firm is currently in or is about to get into the due diligence phase of an M&A deal, a good understanding of the two metrics and their key differences can help you make more sound investment decisions.
Read on as we dissect enterprise value vs. market cap to help you figure out the exact role of each metric in the M&A process.
What is Market Cap?
Market cap, which is short for market capitalization, is the market value of a company’s stock. To calculate market cap, simply multiply a company’s outstanding shares by its current market price per share. Outstanding shares (or shares outstanding) are the total number of shares of a business that its shareholders own.
- Market Cap = Shares Outstanding x Market Price per Share
Here’s an example.
Company X has 10 million shares outstanding. The shares are currently trading at $50 on the stock market. The market cap of Company X is, therefore $500 million (10 million x $50).
As seen, market cap is relatively easy to measure. The two sets of data you need to calculate it are also easily available, usually on the balance sheet of the company of interest, or online at any financial website.
What is Enterprise Value?
While market cap only considers two elements to calculate a company’s value (shares outstanding and market price per share), enterprise value takes several more factors into account. The most important of these other factors are debt and cash.
The basic formula to calculate enterprise value is market cap, plus debt, minus cash.
In our previous example, we found that Company X, with 10 million shares outstanding, which are trading at $50, has a market cap of $500 million (10 million x $50).
Now, let’s say Company X also has $100 million in debt. But, it also has $25 million in cash. Company X’s enterprise value, therefore, is $575 million ($500 million + $100 million – $25 million).
That said, there are some variations of enterprise value that include other factors like preferred stock, minority interest, and cash equivalents in its calculation. The formula to calculate enterprise value then becomes:
- Enterprise Value = (Market Cap + Debt + Market Value of Minority Interest + Market Value of Preferred Stock) – (Cash and Cash Equivalents).
Since enterprise value includes more economic variables like debt and cash, investors usually see it as a more comprehensive measure of a company’s financials.
As is the case with market cap, the figures to calculate enterprise value are available from a company’s balance sheets, or on any major financial website.
Common Ratios Associated with Enterprise Value
When valuing a target firm, you may also employ several EV ratios to dig even deeper into its financials.
EV ratios allow for a comparison of a firm’s enterprise value to its earnings, cash flow, revenue, assets and other metrics. This can tell you whether the firm’s assigned value is fair, or if it’s overvalued or undervalued. Here are some of the most common EV ratios:
- EV/EBIT – Enterprise value to earnings before interest and taxes
- EV/EBITDA – Enterprise value to earnings before interest, taxes, depreciation and amortization
- EV/CFO – Enterprise value to cash flow from operations
- EV/FCF – Enterprise value to free cash flow
- EV/Sales or Revenue
Again, the data to calculate these ratios is available in the company’s balance sheet or from any financial website.
Yet another ratio that can provide more insight into a company’s financials is the EV to market cap ratio, that is, EV/Market Cap. More specifically, this ratio can indicate a company’s debt position and therefore, its perceived risk.
A high EV/Market Cap ratio indicates that a company has more debt than cash, and investors might therefore view it as a higher-risk investment. In contrast, a low EV/Market ratio indicates that a company has less debt and may be a safer investment.
Why Use Market Cap?
Market cap offers a quick snapshot of how investors value a firm in the market relative to others operating within the same sector and/or industry.
You can use the metric to separate companies that are targets of an M&A deal into different categories, such as large-cap, mid-cap, or small-cap. Placing a company into either of these three categories can then give you an idea of the growth and risk potential of its stock.
For example, large-cap businesses (which are firms with over $10bn market cap) are typically less risky than their small and mid-size counterparts. However, they provide both lower and slower growth potential.
Small-cap companies (whose market cap ranges between $300 million and $2 billion) have higher and faster growth potential but are riskier. Such companies are more likely to experience greater share price volatility in periods of economic uncertainty.
Why Use Enterprise Value?
Enterprise value is an important metric during M&As as it represents the theoretical cost to take over a business outright — that is, the minimum price an acquiring firm would have to pay to acquire the target company.
That’s because, in a takeover, the acquiring company assumes the target company’s debt but also receives its cash and/or cash equivalents.
There are firms that carry a significant amount of outstanding debt and others that have huge cash reserves. Valuing such companies based on their market cap alone would therefore provide a misleading picture of the true cost to acquire the business.
This is where enterprise value comes in. Including debt and cash in a firm’s valuation provides a more realistic picture of how much it will cost to acquire it.
Enterprise value is most useful when comparing companies with different capital structures (that is, how a company uses debt vs equity to raise cash). Unlike market cap, which will change if a company’s capital structure changes, a company’s enterprise value is unaffected by capital structure changes.
Enterprise Value vs. Market Cap: So Which One Should You Pay More Attention To?
Both market cap and enterprise value play a unique role in the M&A process, as we have seen.
None is inherently superior to the other during an M&A. Depending on exactly what you’re looking to accomplish, either the market cap alone or the market cap along with the enterprise value will be enough for you to glean what you want from the available data.
Calculate and consider both metrics for the most comprehensive valuation of a firm.
One More Term to Know About in M&As: A Virtual Data Room
When it comes to executing successful M&A deals, understanding the meaning of metrics like market cap and enterprise value and their main differences is crucial. But even more important is having the right tools for the process. And one vital tool you need to have in your arsenal during M&As is a virtual data room (VDR).
A virtual data room is a secure online vault where all parties involved in an M&A, including buyers, brokers, and legal professionals, can store and share sensitive documents and data.
CapLinked is a market leader in the VDR space and can be an invaluable partner in your firm’s next M&A deal. You’ll love its user-friendly workspaces that are easy to set up and manage and that are accessible from any desktop or mobile device.
Further, your CapLinked VDR comes with several cutting-edge features, including document and version management, collaboration tools, and customizable permissions, to streamline the due diligence process of your firm’s M&As, saving you time and money.
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Mergers and Inquisitions: https://mergersandinquisitions.com/enterprise-value-vs-equity-value/