Enterprise value is a calculation used to determine a valuation for a takeover target. Enterprise value is a good representation of the cost that an acquirer would incur if it were to purchase another business, since it represents the additional costs associated with the purchase, other than the market price of the shares that must be purchased.
The calculation of enterprise value is as follows:
+ Market value of target company shares outstanding
+ Debt of target company
+ Minority interest
+ Unfunded pension liabilities
+ Preferred shares outstanding
- Cash and cash equivalents
= Enterprise value
For example, Blue Company is considering the acquisition of Green Company. There are 1,000,000 shares of Green stock outstanding, which currently sell at $8.00 each. Thus, the market value of the shares outstanding is $8,000,000. Green also has $1,000,000 of preferred shares outstanding, and owes a lender $250,000 on a short-term loan. The company has $100,000 of cash on hand. Based on this information, the enterprise value of Green Company is:
+ $8,000,000 Market value of shares outstanding
+ $1,000,000 Preferred stock
+ 250,000 Short-term loan
- 100,000 Cash on hand
= $9,150,000 Enterprise value
Thus, other factors have greatly increased the price of the prospective deal. By comparison, if Blue Company were looking at a more fiscally conservative target company that had no debt, but which was the same in all other respects, the valuation of the business would be notably lower.
An even more accurate variation on the concept includes the following additional factors:
- Include the control premium that must be paid in order to actually buy shares - since a premium must usually be offered before shareholders will be tempted to tender their shares to the acquirer.
- Exclude that portion of the cash that must be retained to operate the target company. Ordinarily, the calculation assumes that all cash outstanding is paid to the buyer as a dividend, but in reality, most of the cash is needed to fund ongoing operations.
The enterprise value concept is clearly superior to just using market value to calculate the acquisition cost of a target company. As revealed by the example, there are a number of other factors that can result in a significantly different (and more realistic) valuation than the simple market value calculation.
This is not the only method available for valuing a business, but should certainly be calculated along with other measures to arrive at a range of possible valuation amounts.