Sunday 17 April 2016

Enterprise Value

Have you heard of enterprise value? Instead of simply using share prices and market cap (which are almost the same, just that one shows the price of a small part of the company being traded while the other shows the price of the whole company at the current price), enterprise value is another measure that you may consider using when evaluating investments.

What makes enterprise value a better measure than market cap or the price of the shares is that it takes into account more details of the company such as its debt, cash position and minority interests. For companies listed on the SGX, the enterprise values can be found by looking at the financials tab in the company's information page. For those that do not have their values listed or you want to check, you can calculate the enterprise value of the company by using the following formula (from Investopedia):

Enterprise value = Market cap + Market value of debt and preferred securities + Minority Interest - Cash and cash equivalents

What is the enterprise value aiming to calculate? Its goal is to calculate the price that a person acquiring the business (at its current market price) would have to pay for the company. It takes into account the debt and the minority interest as someone taking over the company would also have to take on the company's debt (which can be purchased at market value) and wouldn't have the parts that the minority interests own, while the cash in the company can be used to offset its purchase price and hence is deducted from the enterprise value.

(Side note: I usually use the value of the company's debt on its balance sheet rather than the market value since that one is usually easier to obtain, but if possible, I try to use the market value since that would be the true price that the acquirer would have to pay to purchase all the company's debt)

Using this measure would give cash-rich companies (such as Hock Lian Seng, which I've covered earlier) an advantage over measurements using just their share prices such as P/E ratios as it takes into account their high cash position. Companies will little debt may also benefit from this if they have enough cash to cover their debt. On the other hand, it would penalise highly leveraged companies, such as some of the smaller oil and gas companies. This makes it easier to compare the companies and levels the playing field since debt can help to increase the company's value (the company makes the difference between its return on the amount and the interest that it is paying) but also makes the company more risky since it would have to consistently find sources of funding and pay interest even when the company is not performing well. So, enterprise value helps by penalising the companies with high levels of debt, making it easier to value them in comparison to companies with smaller levels of debt and larger cash positions.

But when using enterprise value, instead of using net profit attributable to shareholders, I would use the EBIT and minus off the tax to get earnings before interest, which is the more accurate measure of the profits generated by the business (since by using enterprise value we pay the price of acquiring the debt and minority interest).

While I've been using the company's debt and cash on hand during my analysis of companies, now I've found a more reliable way of comparing companies, with their different debt-to-equity ratios and amount of cash and cash equivalents, which may help to make evaluating companies easier.

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