The term “Enterprise Value” (EV) represents the total value of a company, defined in terms of its financing. It includes the current share price (market capitalisation) and the cost to pay off debt (net debt, or debt minus cash). Combining these two figures helps establish the company’s enterprise value.
“Enterprise value calculates the potential cost to acquire a business based on the company’s capital structure. To calculate enterprise value, take current shareholder price, for a public company, that’s market capitalisation. Add outstanding debt and then subtract available cash. Enterprise value is often used to determine acquisition prices. It’s also used in many metrics that compare the relative performance of different companies, such as valuation multiples,” Oracle NetSuit explained.
Enterprise value is a financing calculation, the amount a business leader needs to pay to those having a financial interest in his/her venture. That includes everyone owning equity (shareholders), as well as the lenders. If someone buys a company with debts, he/she needs to pay up for the stock and then pay off the debt, but the person gets the company’s cash reserves upon acquisition. Because you receive that cash, it means you paid that much less to buy the company. That’s why you add the debt but subtract the cash when calculating an acquisition target’s enterprise value.
Knowing The Concept In Detail
Conceptually, enterprise value gives an entrepreneur a realistic starting point for what he/she would need to spend to acquire a public company outright. In reality, as per Oracle NetSuit, it typically takes a premium to EV for an acquisition offer to be accepted. This happens due to reasons like the company’s board demanding a premium to its current share price, before the venture goes for the sale. Also, when an acquirer starts buying stock, the economic principles of supply and demand typically kick in, driving up the share price. During the bidding stage, multiple bidders emerge, leading to a significant premium.
“A company’s enterprise value is not reflected solely in its shareholder contribution, the amount of money contributed to a business by shareholders; it also takes into account company debt, both short- and long-term, and cash reserves. While debt and cash are clear and simple terms, market cap deserves a bit of explanation,” Oracle NetSuit added.
People often discuss a company’s stock price and whether it has gone up or down. However, the actual price of a share of a stock is meaningless in terms of understanding a company’s value without additional data, particularly how many shares are outstanding. Multiplying the share price by the number of outstanding shares gives the exact information about the company’s market capitalisation, and the total dollar value of the company’s outstanding shares.
“As a simple example, Company A’s stock may trade at USD 100 per share while Company B’s stock trades at USD 20. But if Co. A has 100 million shares outstanding and Co. B has 500 million shares outstanding, then their market caps are precisely the same: USD 10 billion,” Oracle NetSuit continued.
However, the idea of enterprise value suffers from a limitation, especially when it comes to comparing dissimilar companies. Enterprise value holistically quantifies how much a company would cost to take over, rather than simply its value in terms of market capitalisation. 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 acquire.
“However, EV doesn’t consider how companies make use of the debt they carry. A software company with significant debt and few cash reserves may be a less attractive investment than a company with similar market cap and no debt, but the investment decision wouldn’t be as clear-cut when deciding between different industries. A utilities company or auto manufacturer, or any other capital-intensive industry, would likely need to incur a significant amount of debt to finance the capital needed to generate revenue,” Oracle NetSuit stated.
EV becomes more useful in the case of comparing companies at similar stages of growth. Companies in a phase of high growth are less likely to have as much debt as a more mature company.
Increasing EV For Small Businesses: Here Are The Tips
Does EV matter for small businesses? Yes, in the opinion of Michael Evans, Managing Director and Chief Financial Officer for Newport, LLC, a partnership of board directors and senior executive leaders with deep knowledge of business strategy, operations, and capital markets.
“Small business owners often have their heart and soul tied up in their business, not to mention most of their cash! Typically, your company will be your largest investment and just as you may have a wealth manager for your other personal investments; you also need to wealth manage your business. The day may come when you will be looking at an exit strategy, and clean and lean companies bring the highest price,” Evans wrote in his article titled “How to Increase Your Enterprise Value,” published in AllBusiness.
When it comes to pulling off exit strategies, private business owners (including small business owners) can better prepare their company for an exit strategy or simply increase the value of their business for their family by focusing on the three legs of the value stool: strategic, financial and operational improvement. Together, these legs, if coordinated and approached methodically, can significantly result in a more valuable company. The concept is called building enterprise value.
Evans explains these legs as “Strategic Improvement,” “Financial Improvement,” and “Operational Improvement.” Under the strategic part, the private business owners need to focus on the venture’s roadmap in order to build its enterprise value. This means positioning the direction of the company in the marketplace via four key strategic considerations. The management team needs to figure out which customers the company should serve, apart from developing new capabilities to power innovation, generate sales, and operate more efficiently than the competitors and be focussed.
The management team also needs to build a profitable economic model at a higher scale while increasing the leverage that makes the company profitable. Also, infrastructure should be created to support operational growth, apart from having access to capital to fund the predicted level of growth. The company also needs to be open to the idea of raising capital to fund growth, consistent with its vision and risk appetite. And while raising the capital; be aware of the operating changes a new capital structure will entail.
When it comes to “Financial Improvement,” it involves maximising cash flow, balancing fixed and non-fixed assets, maintaining a current ratio sufficient to cover unforeseen costs and balancing short-and long-term financing needs. This includes optimising the company’s balance sheet, cash flow and income statement. Key initiatives include restructuring capital structure to take advantage of lower market interest rates, renegotiating supplier terms (for example to shift inventory storage and maintenance costs), reviewing the venture’s payment practices, especially payment terms with suppliers and sales terms with customers and figuring out whether these conditions are more generous than the venture’s competitors.
Also, the venture needs to ask itself whether it has a large enough cash cushion to sustain the business in the event of a downturn. Is it taking full advantage of tax strategies (including tax-saving opportunities)?
The last leg, known as “Operational Improvement,” helps build enterprise value involving fine-tuning a business’ internal operations. One very good application area is the supply chain; where the company’s management team puts the “Operational Improvement” into practice by sourcing and aggregating more efficiently the inputs that the company makes into products/services. The company also needs to be open to re-configuring its activities, for example, replacing part of its sales force with contract resources that specialise in tasks like direct marketing and prospecting leads, apart from exploring “virtual models” including using social and business networks.
The company can also consider contract services (for example, call centre, order fulfilment), whether onshore or offshore, to do activities that are not core to adding value. The management team can further reduce the production cost by sourcing from new suppliers, thereby avoiding dependency on too few.