What Is Enterprise Value?
Enterprise value represents the cost someone would have to pay to take over a company. In theory, enterprise value is the minimum of what a company is estimated to be worth on the market. Because assets, debts and cash all contribute to a company's overall value, someone looking to acquire a particular company should weigh all of these factors before making a final decision about whether or not to purchase the company.
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Features
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The formula for calculating enterprise value subtracts whatever cash a company may have in the bank from its market value, then adds to that the cost of any outstanding debts. For a more accurate estimate of a company's enterprise value, debt usually includes preferred stock, which is considered to be another form of equity. Cash may also be adjusted to include cash equivalents, such as accounts receivable and liquid inventory. These specifics are important, as the total amount of debt can increase how much a buyer is paying for a company. Likewise, the amount of cash a company has on hand at the time of purchase means that the buyer is paying less for the company. A potential investor should always compare a company's earnings and sales to its enterprise value, as well as take a look at how much cash flow the company generates.
Misconceptions
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Market capitalization, which is the total market value of a company, is calculated by multiplying the total number of remaining shares by the current price per share. However, only looking at market capitalization can be misleading to a potential buyer. The truth is that there a number of different factors that can affect stock prices on Wall Street.
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Benefits
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Enterprise value represents a better idea of how much a company is really worth, because it considers more than simply the value of the company's outstanding equity. Anyone taking over a company also acquires that company's debts and any cash. If there were cash in the bank, a new owner would also gain that amount of cash as part of the purchase, thereby reducing the cost of buying the company.
Considerations
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As a general rule of thumb, someone who is thinking about making a major investment in a company is looking to make the greatest profit at the lowest cost. A company that generates a strong cash flow typically requires fewer reinvestment costs, and therefore would be more likely to attract a potential buyer. Companies that have significant debt and no cash despite high market values often turn out to be expensive acquisitions in the end.
Warning
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The more debt a company owes to its creditors, the more it will cost a buyer to purchase that company. Liabilities are a company's specific obligations, and can make a huge difference in how much the company will cost to purchase. A potential buyer must consider that the cost of buying a company not only includes buying shares of the company's stock, but also includes becoming responsible for paying any of the company's outstanding debts. Taking over a company with substantial debt means that a buyer could end up paying more for the company, as that person would be obligated to pay off those debts. Consequently, a company that has less debt and reports more cash flow is usually viewed as a more sensible purchase.
Expert Insight
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Many economists and educators in the field of finance say that it is important to take a look at all of a company's economic and business activities over time to develop a better idea of its operations. Financial experts maintain that the overall value of a company cannot be assessed by any one single factor. While analyzing returns and cash flows is critical to the success of a business, some of today's most profitable companies are now looking beyond the numbers and taking advantage of opportunities to develop new ideas. Corporate responsibility is about more than making the greatest profit at the least risk. Improving performance and creating new opportunities by identifying and serving different sectors of the market are becoming increasingly important in the business world. Economic theory is expanding the definition of market value to allow for the potential of new innovations and business technologies.
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