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Know What Your Business is Worth

Understanding Enterprise Value

The number one reason most transactions fail to reach the finish line is that most business owners don't understand the enterprise value of their business. The simple fact is that most business owners have unrealistic expectations of enterprise value. Instead, they need to take the time to understand how businesses' valuations work in their space or to see where their business stands by obtaining an estimate of the value of the business.



That's a big mistake.


Business owners are solicited all the time by buyers. When those unsolicited offers come to your inbox, you will know if it's a good deal or a bad one if you know your Enterprise Value. Too, when it's time to put the business on the market, too many business owners list the business for an unrealistic price based on emotion rather than solid market facts. A business seeking a purchase price far over the actual value will likely sit on the market with few or no offers.


Good business owners who want to be in the 17% of business owners who successfully exit need to understand enterprise value. We will start with the basic concepts.

What is Enterprise value?


Enterprise value (EV) is simply the total value of a company. It looks at the entire market value, so all market capitalization and the cost to pay off short-term and long-term debt and any cash are included in that number. It tells investors or interested parties a company's value and how much another company would need if it wanted to purchase that company.


A simple formula for enterprise value is:


EV = Market Capitalization + Market Value of Debt - Cash and Equivalents


Note: The Enterprise Value does not translate to the Selling Price. It is one of the many factors that determine the selling price.


What are the elements of Enterprise Value?


Four elements comprise enterprise value:


Market cap: The value of common shares of the company.

Debt: The sum of long-term debt and short-term debt.

Minority interest: The portion of subsidiaries that the minority shareholders hold.

Cash and investments: The total amount of cash, certificates of deposit, drafts, money orders, commercial paper, marketable securities, money market funds, short-term government bonds, or Treasury bills a company possesses.


Here is an example of how to calculate enterprise value using Tesla (NASDAQ: TSLA). Based on the company's share price on Sept. 20, 2021, and the number of shares outstanding at the end of the second quarter of 2021, Tesla's market cap stood at $730 billion. At the end of the second quarter, the company reported total debt of $9.4 billion and cash and equivalents of $16.2 billion. Here is Tesla's calculated enterprise value:


EV = $730 billion + $9.4 billion-$16.2 billion = $723 billion


In the Mergers & Acquisitions world, a buyer wants to know the debt position of the company they are trying to acquire. Investors use EV to determine the actual size of the company, along with evaluating the company's debt management.


Some companies, at first glance, may look overpriced when you only use the market cap to determine value. But when you factor in no debt and a large cash balance, the enterprise value looks different—starting to understand why EV is so important.


Why do you want to use Enterprise Value and not just market Capitalization?


Market cap leaves out many factors in a company's value, such as company debt and cash reserves. Enterprise value is a more thorough calculation that provides clearer insight into the real value of the business than market cap does. For example, The table below shows companies with the same market cap but very different enterprise values.


Market Cap

Debt

Cash

Enterprise Value

Company A

$10B

$2B

$0

$12B

Company B

$10 B

$0

$2B

$8B

Important multiples of Enterprise Value


EV / EBITDA: ( Earnings Before Interest, Taxes, Depreciation, and Amortization).EBITDA measures a company's ability to generate revenue and as an alternative to simple earnings, to value capital-intensive businesses, compare firms with different degrees of financial leverage, and helps in comparing companies with different capital structures


EV / Sales: It is a preferred ratio to Price / Sales as it accounts for the debt component to be reimbursable. The lower the EV / Sales ratio, the more attractive or undervalued the company.


EV / EBIT: Comparing enterprise value against earnings before interest and taxes(EBIT) will display how a company's stock prices and debts minus their cash reserves are holding up when it comes to their profits. Additionally, it serves as a similar financial metric without the limitation of removing depreciation and amortization expenses related to property, plant, and equipment.


EV/ book value: To evaluate your company's book value, you measure asset by asset rather than a whole amount. Comparing book value against enterprise value can help you see the company's financial health more closely.


EV/ price-to-earnings ratio: A price-to-earnings or P/E ratio tracks a given stock's price against how much it's earning. Taking this into account provides an even more in-depth look at a company's market cap and, as a result, a more well-rounded look at its enterprise value. The P/E ratio fails to consider the company's debt on its balance sheet.


Are there any Limitations on Enterprise Value?


Enterprise value includes total debt, which could be an issue because we might need to learn how the company uses debt. For example, if two companies have the same market cap but one has significant debt while the other has significant cash reserves, the company without the debt would cost less to buy. However, EV doesn't consider how companies use the debt they carry. For example, capital-intensive industries typically have a significant level of debt. With this example, this debt is cultivating growth (funding the purchase of equipment, making investments, etc.) So, while the enterprise value calculation skews against these companies in favor of businesses in zero-debt industries, you may be missing the overall picture by relying on enterprise value.

Why is this helpful to know for your business?


Now that you better understand how enterprise value works, your mindset shifts.


You manage your expectations of what your business is worth. It is an actual number.

You manage your business differently. Your strategic planning goes to a whole new level. Your focus shifts from managing your "baby" to creating an "asset."


You should know the value of your business.

We can do one for you. Tons of business valuation firms will do it for you. Just do it.


At Mastery Partners, calculating enterprise value is part of our process. We know every year where our clients stand regarding Enterprise Value. You should too. It is just good business.







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