What is Enterprise Value?
A public corporation accesses the capital and debt markets to get funding to run its business but in the process their equity (stock) and liabilities (debt) now have several public owners. Let's assume that a group of investors wanted to take a company from public to private, how much money would they have to theoretically come up with to do so?
The answer to this question is a measure of how much it would take to take over a company entirely and is called Enterprise Value.
To theoretically acquire a company you would need to:
a) Buy all of its stock (equity)
b) Assume and now be responsible for all that it owes (liabilities)
c) Assume and now be responsible for all that it has (assets)
The total Enterprise Value will therefore contain the following elements:
Enterprise Value=Market Capitalization + debt + preferred equity + minority interest - cash (and cash equivalents) - associate companies.
Market Capitalization: Total number of outstanding shares multiplied by its share price
Debt=Short-term and long-term debt
Preferred Equity: Hybrid between debt and equity that has a higher priority than common shares but lower than debt in the capital structure.
Minority Interest: Portion of a subsidiary belonging to the company that has separate ownership (subsidiaries are companies where the parent owns more than 50% of the equity).
Cash and Cash Equivalents: All cash or cash-like instruments
Associate Companies: Ownership of other businesses and therefore assets to the company (at market value)
In most simple cases, the Enterprise Value will be simply the Market Capitalization plus the debt that you assume when taking over the company, minus the cash in the companies' books (since you inherit it by taking over the company).
Keep in mind that Enterprise Value is a theoretical value that is useful to us as investors or traders but that would not be accurate in the actual event of a takeover, and acquisition or a merger. This is because normally the acquirer would have to entice current shareholders to tender (sell) their shares to them and in order to do so, normally the acquirer will offer a premium over the current market price of the shares in order for most shareholders to agree with the transaction.
In very simple terms for us as investors or traders, Enterprise Value is important to fully understand the size of the company that we intend to invest in or trade. By doing so we would have a good idea of whether our company could be the target of an acquisition by a larger rival or whether maybe the company could be a potential acquirer. This is very important as M&A (mergers and acquisitions) is a very important event for a company (as a target or an acquirer) and it causes large moves in its stock price whether responding to market rumours or to actual offers.
In most cases where there is an actual offer to buy out a company the shares of the target company will go higher (as they are now an asset that is being pursued by a suitor and could potentially even lead to a bidding war) whereas the stock of the acquirer will normally go down. This is because the market tries to assess the challenges of implementing the two companies together and whether the transaction was financed with cash or with shares or if the acquirer will take on debt to make the acquisition.
In any event, it pays to know about the Enterprise Value of the company that we are analyzing so that we are aware of potential transactions that might occur (or even the mere rumour of it) and the effect it would have in its stock price.
An example of an actual M&A transaction (that ultimately failed but provided traders with great trading opportunities) was Microsoft's (ticker: MSFT) attempt to buy out Yahoo (ticker: YHOO). This happened on Feb. 1st, 2008. Yahoo was trading at $19.18 the day before Microsoft made a public offer of $31 per share. Yahoo closed the next day at $28.38 or almost 48% higher than the day before. The reason the market didn't price in the full $31 per share offer by Microsoft was because the market was not certain that the transaction would actually take place as indeed it turned out to be the case. As of this writing more than two years after the initial offer, Yahoo is trading at $15.24, much lower than the amount that Microsoft offered and Yahoo turned down.