Market Capitalization & Enterprise Value: What’s the Difference?
When valuing a company, it’s important to be able to put a number on that valuation with which you can compare it to other companies, to thus make a quick comparison between their relative value. Two ways to measure the market value of a company are market capitalization and enterprise value. Both measure the value of a company, and both are good ways to compare two different companies, but the terms are not interchangeable, and you cannot, for example compare Apple’s market capitalization to Microsoft’s enterprise value to get an accurate and useful comparison. You have to compare the individual measurements and, based on the pros and cons of each, decide which you will use for comparing both companies.
What Is Market Capitalization?
Market capitalization (sometimes called “market cap”) is a relatively simple way to calculate a company’s size and value, and therefore its potential growth rate and risk outlook.
Very basically, marketing capitalization is the total value of all outstanding shares of a company. The calculation is an easy one: you take a look at how many shares a company has outstanding (let’s say one million) and its stock price (let’s say $18), and you come to a market cap value of $18 million. It really is that simple.
The benefit of market cap is that it can give you an idea of the growth and risk to expect from a certain stock. There are three categories of market capitalization: large, mid, and small-cap. Large-cap companies are established companies with steady streams of revenue. Growth may not be as lightning-fast as a startup, but it is steady and reliable. They have swings in their price share, but they’re not volatile.
A small-cap company has an often rapid growth, but with more volatility.
A good example is an old standard stock: ABC Manufacturing. They might have a low stock price, say $5, but their market capitalization is $18 billion. This is because they’ve been around for so long and have been steady and expanded over the years that they are worth quite a bit despite the low stock price.
On the other hand, take XYZ Technology, the latest and greatest startup with promising new ideas. Their stock price may be significantly higher: let’s say $20, but their market cap is $100 million.
The difference between these two companies is that one has grown over many years and multiplied and expanded, where the other is priced high, but is still new to the market. This is all valuable to know, but you wouldn’t necessarily get it from looking straight at the companies’ market cap. That number, alone, doesn’t tell all the story. You have to dig in.
So what is enterprise value, and how does it differ from market capitalization? The biggest difference is that enterprise value takes into account one of a company’s most important factors: that company’s debt. Therefore, it is considered a more accurate measure of a company’s worth.
The calculation for an enterprise value is more complicated than that of a market cap: you have to add the market cap to the outstanding preferred stock and all debt obligations, and then subtract all of its cash.
Enterprise value has long been used by savvy value investors as a way to determine if a company is undervalued (or overvalued) in the market. A company might have a great market capitalization, but have serious debt obligations hiding beneath the surface.
Comparing enterprise value to enterprise value gives you a much clearer vision of a company’s health–and whether or not you should invest in it.
EV/Market Cap Ratio
A final way of looking at the value of a company–a good, quick valuation number–is to examine their EV/Market Cap Ratio. If a company has an EV/Market Cap ratio (determined simply by dividing the EV by the Market Cap) of more than 1, then you know that the company has more cash on hand than debt.
If Company Alpha has a Market Cap of $200 billion but an Enterprise Value of $600 billion, then that would give it an EV/Market Cap Ratio of 3. This is very good, as it shows the company has little-to-no debt and large cash reserves.
If Company Beta has a Market Cap of $200 billion, but an Enterprise Value of $100 billion, then it has an EV/Market Cap Ratio of 0.5, meaning it is in a lot of debt, and potentially very risky should the economy go south.
This shows how looking at the Market Capitalization doesn’t show the whole picture and is not the best number to look at when determining whether to purchase a stock: Company Alpha’s stock is probably undervalued, because it’s Enterprise Value is so high, whereas Company Beta is probably overvalued.