Enterprise value (EV) represents a company's economic value -- the minimum amount someone would have to pay to buy it outright. It's an important number to consider when you're valuing a stock.
You may remember that market capitalization (the current stock price multiplied by the number of shares outstanding) also serves as a company's price tag. But market cap ignores debt, and with some companies, debt is substantial enough to change the picture significantly. Enterprise value, on the other hand, is a modification of market cap that incorporates debt.
To better understand the concept of enterprise value, imagine that you're looking at two companies that have equal market caps. One has no debt on its balance sheet, while the other one is rather debt-heavy. Whoever owns the latter company will be stuck making lots of interest payments over the years -- so you probably wouldn't pay the same price for each company.
By the same token, imagine that you have two companies with equal market caps of $50 billion and no debt. One has negligible cash and cash equivalents on hand, and the other has $5 billion in cash in its coffers. If you bought the first company for $50 billion, you'd have a company worth, presumably, $50 billion. But if you bought the second company for $50 billion, it would have cost you just $45 billion, since you instantly have $5 billion in cash. These are the kinds of things enterprise value takes into account.
To calculate enterprise value, start with a company's market cap, add debt (found on a company's balance sheet), and subtract cash and investments (also on the balance sheet). To get total debt, add together long- and short-term debt.
- Market cap = current share price * total shares outstanding
- Debt = long-term debt + short-term debt
- Enterprise value = market capitalization - cash and equivalents + debt
Let's examine Motley Fool Income Investor recommendation Kraft Foods (NYSE: KFT ) , using its quarterly earnings report for the quarter ended in June 2005. Its roughly 1.7 billion shares, at a recent stock price at the time of this writing of about $28.52, yield a market cap of around $48 billion. To that, we add its $11.1 billion in debt and subtract its $396 million in cash and cash equivalents. The result is $59.2 billion, a significantly higher number than the market cap.
Debt can make a big difference. If you paid $48 billion for Kraft, you would actually end up with a total bill of $59 billion, because the company comes with a lot of debt. The enterprise value reminds all investors, large and small, that debt is a cost to the business.
Shifting from the concept of corporate debt to personal debt, are you overloaded with borrowings? Learn more in our Credit Center.
And by the way, if thinking about investing makes your head hurt and you'd like an actual person (a financial pro, no less) to talk with about your financial situation, look into our TMF Money Advisor. It's a valuable service that features customized independent advice from a variety of objective financial experts. You need to make sure you're saving enough, and well enough, to meet all your needs. (To take savings matters into your own hands, visit our Savings Center.)
Selena Maranjian, Shruti Basavaraj, and Adrian Rush contributed to this article.