Enterprise Value

The financial world loves an acronym. Actually it is obsessed by abbreviation and jargon to the extent that it has almost created a new language. It is an uncommon talent for two protagonists to engage in a conversation that would be incomprehensible to anyone not in the know. In our world it is all too easy. This article tackles ‘EV’ or, to give it its full title, Enterprise Value.

This is a rare concept. It is simple, well thought out and genuinely useful, qualities that have been lacking from the topics of most of our previous discussions. Enterprise Value is a self-explanatory term: it gives a value for the whole of an enterprise. The key concept to grasp is that this is not the value of the equity, jargonized as the ‘market capitalization’ of a company. Instead it takes account of the debts and cash as well.

This can make an enormous difference. Remember the headlines after Royal Dutch Shell’s bid for BG Group? They were broadly along the lines of ‘Shell agrees to buy BG for £47bn’. If only that were true. The vaunted £47bn is only the value of BG’s equity. On top of this, Shell will be taking on an extra £10.5bn ($15.9bn) of BG’s debts. The full cost to Shell is actually BG’s Enterprise Value £57.7bn: 22% more than it is reported to be paying.

Imagine that BG’s more than £10bn of debts were cash instead. This would reduce the Enterprise Value to £36.5bn. Had this been the case the informed comments would doubtless have been that Shell was paying only this lower number, rather than the full £47bn.

There are two means of arriving at an Enterprise Value: the quick and easy, or the slightly slower and more complicated. The former is no more or less than the market capitalization plus debt (or minus cash). The latter (the full and correct) is the market value of common and preferred equity, plus the market value of debts, plus minority interests, minus cash and investments. It is usually just simpler to use the quick and dirty rule of thumb.

Enterprise Value is sadly underused in financial analysis. Let me illustrate this with the price-to-earnings (p/e) ratio. As we explored in greater depth in another article, this is the price of share divided by the amount of post-tax profits attributable to each share. It is still one of the most commonly used means of equity valuation. But it would be so much better if everyone used the EV and not the price of the equity.

Let’s take the real example of the train operator First Group (FGP) to illustrate this. I am using rounded numbers for simplicity’s sake. The current share price is 100p and last year FGP earned 7.5p per share after tax, a p/e of 13.3. But on top of First Group’s £1.2bn of equity it has debt of £1.8bn and cash of £550m. The EV is therefore £1.2bn + £1.8bn less £550m, making £2.45bn in total, or 204p per share. Thus the real, or EV-based p/e is actually 27: more than double what we first thought.

Enterprise Value is accurately named, simple, useful and underused.

It may even catch on.