Market Capitalization can be used to determine how much a company worth at a point of time, or "how big" a company is. However, there is a more accurate measure of a company's value, which is the Enterprise value.
The calculation of Market Cap is quite straight forward,
Market Cap = Share Price x Total Outstanding Shares
Enterprise Value (EV) is also not hard to calculate,
EV = Market Cap + Debt + Minority Interest + Preferred Shares - Cash & cash equivalent
All the figures except market cap can be obtained from the balance sheet.
EV is a theoretical takeover price. It is widely considered as a more accurate representation of a company's value.
When company A wishes to takeover or acquire company B, it needs to:
- pay company B's ordinary shares holders (market capitalization)
- pay company B's total debt
- pay company B's minority interest shareholders
- pay company B's preferred shares holders
However, company A does not need to pay for company B's cash. It will pocket the cash.
After obtaining the EV, we can calculate a company's Enterprise Value Multiple (EVM), which is one of the investment valuation ratio like the more commonly used PE ratio.
EVM = EV / EBITDA
EBITDA = Earning Before Interest, Tax, Depreciation & Amortization
EVM roughly tells how long it would take for an acquisition to earn enough to pay off its cost, assuming that there is no change in its annual EBITDA.
If EVM is 10, then it will take 10 years. Thus, the lower the number the better it is.
EVM might be a better valuation ratio compared to PE ratio as it includes a company's earning, debt and cash into the valuation, while PE ratio is only about a company's earning.
Like any other financial ratios, it is best to compare with peers and historical data.
sense maker
EVM is widely used by businessmen looking to acquire a controlling stake in a company because net cash or debt affects their financing or cash flow planfor the acquired company post-acquisition.
But there is a pitfall small investors should be aware of when using it. There are some companies that sit on big cash for decades without making dividend distribution. Companies with very high net cash per share, some higher than market price per share, would have negative or < 1 EVM, although their profitability gauges are super low (like ROE, ROA).
2013-12-07 17:52