Using the Enterprise Value Ratio

In John Bajkowksi’s First Cut column in the June 2008 issue of the AAII Journal, he discussed how to use “enterprise value” to locate bargains in the stock market (the article is available online at AAII.com). The enterprise value, or EV, is the value the market places on a firm as a whole.

Calculating Enterprise Value

Enterprise value is an economic measure reflecting the market value of a company as a whole business. It is the sum of claims of all security-holders: common and preferred equity holders, minority shareholders, debtholders, and others. Looking at enterprise value from this standpoint, you buy the enterprise value of a company after you settle with all the security holders.

A more simplistic view of enterprise value is as the sum of a company’s market capitalization and its net debt.

For this calculation, you start with the company’s market capitalization—share price multiplied by the number of shares outstanding—and add to it total debt (short- and long-term debt reported on the balance sheet), and then subtract from it the company’s cash and cash equivalents (which are also reported on the balance sheet).

Alternative to Market Cap

Enterprise value measures how much you would need to pay to buy an entire public company. Some analysts believe it provides a clearer picture of the “real value” than market capitalization.

In contrast, market cap tells you how much you would have to pay to buy every share of the company. However, market cap leaves out several important factors, namely the company’s debt and its cash reserves. Therefore, rather than telling you the company’s value, market capitalization represents the company’s price tag.

Role of Debt & Cash

When a company is sold to a new owner, the buyer pays for the equity value—which is typically set higher than the market value—and must also repay the firm’s debts. However, the buyer also gets to keep the cash the firm has. This is why the cash balance must be deducted from the firm’s market capitalization.

Consider, as an example, two firms with the same market cap. However, one has no debt on its balance sheet while the other has a heavy debt burden. The high-debt firm must make interest payments on this debt. Likewise, preferred stock and convertible securities that also pay interest should be considered when calculating the company’s value. So the company with debt has a higher enterprise value.

Now, let’s consider two companies, again with the same market cap. However, this time one company carries little or no cash or cash equivalents on its balance sheet while the other carries $500 million in cash. If you bought the company with no cash for $500 million, the value of the firm would still, presumably, be $500 million. However, if you bought the second company for $1 billion, it would have cost you only $500 million, since you get to pocket the $500 million in cash.

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If a company with a market cap of $500 million also carries $200 million in long-term debt, the buyer would ultimately pay much more than $500 million if they were to buy all of the company’s stock. This is because the buyer must also assume the $200 million in debt, which means the total acquisition price would be $700 million. So, long-term debt effectively increases the value of a company. Therefore, any measure of value that only takes into account the cost of the company’s stock is, at best, incomplete.

Keep in mind that the “market price” of a company’s debt may be significantly different from the price at which an entire debt issue could be purchased in the open market. Using the book value of debt in the enterprise value calculation is a more conservative approach.

In contrast, cash and cash equivalents have the opposite impact on a company’s value. They actually decrease the net price a buyer ultimately pays. If a company has a market cap of $500 million and $100 million in cash on the books, the buyer would still have to pay $500 million to get the equity. However, they would also recoup $100 million from the cash holdings, thereby lowering the effective price to only $400 million. Likewise, if the buyer were to use the cash to pay down the debt of the company they were buying, this too would lower the net cost of the acquisition.

Interpreting Enterprise Value

We now turn our attention to calculating enterprise value for a publicly traded company. 3PAR PAR has been in the headlines recently after a bidding war for the company broke out between Dell and Hewlett-Packard. Dell launched a takeover bid of 3PAR, initially offering $18 per share, but Hewlett-Packard eventually won out with its offer of $33 a share.

Table 1 shows the enterprise calculation for 3PAR using data of as June 30, 2010. 3PAR shares closed at $9.10 on June 30, 2010. According to the company’s latest quarterly SEC filing, the company had 62.6 million shares outstanding as of the same date, giving it a market cap at the time of $570.6 million. The company has no short- or long-term debt, nor does it have any preferred shares outstanding. As of June 30, 2010, the book value of 3PAR’s cash and cash equivalents was $29.9 million, giving the company an enterprise value of $540.7 million.

Moving ahead to the present time, the company’s enterprise value has mushroomed to over $2 billion, as the price has jumped from $9.10 to $32.89 (closing price as of September 3, 2010).

The Enterprise Multiple

There are several ways to use enterprise value when evaluating a company, but the one that is used most is the EV-to-EBITDA ratio, or the enterprise multiple. This metric compares enterprise value to earnings before interest, taxes, depreciation and amortization, or EBITDA. EBITDA ignores non-cash expenses such as depreciation of fixed assets that have already been purchased and amortization of intangible assets such as goodwill since these expenses do not impact pretax cash flow. EBITDA also ignores taxes and operating interest payments, which are likely to change following an acquisition or merger.

Generally speaking, the enterprise multiple relates a firm’s takeover cost to its earnings potential. As such, it serves as a rough proxy of how long it would take for an acquisition to earn enough to pay off its costs (assuming that EBITDA does not change following the acquisition). Therefore, a company with a low multiple may be a potential takeover target.

Returning to our discussion of 3PAR, Table 2 shows the components of the company’s EBITDA calculation as well as its enterprise multiple. For the trailing 12 months ending June 30, 2010, the company had a net loss of $3.2 million. Since 3PAR has no debt, there were no operating interest expenses to add back. The company paid $300,000 in income taxes over the last 12 months and had depreciation and amortization expenses of $8.6 million over the same period. Adding these items back to net income gives 3PAR an EBITDA of $5.7 million for the 12 months ending June 30, 2010.

Dividing 3PAR’s EBITDA into its enterprise value of $540.7 million gives the company an enterprise multiple value of 94.9 as of the end of June. Moving forward to September 3, the enterprise multiple had jumped to over 356 due to the 261% increase in the price of PAR shares. Another way to look at this number is that, assuming the company’s EBITDA does not change following Hewlett-Packard’s acquisition, it would take just over 356 years for the acquisition to pay for itself. Obviously H-P is expecting 3PAR’s revenues to increase going forward, as more companies look to make use of its on-demand data storage capabilities.

Like any kind of ratio analysis, enterprise multiples can vary depending on the industry. Therefore, it is important to compare multiples of companies in the same industry. In general, expect higher enterprise multiples in high-growth industries and lower multiples in industries with slow growth.