While market cap is a valuable measurement, it has some limitations when it comes to determining the true size and worth of a company. Enterprise value is a holistic measure of a business’s worth that includes all aspects of its capital structure, including cash and debt.
The formula used to calculate a company’s enterprise value is easy : current shareholder price (market cap) plus the total of short- and long-term debt, plus the total of all preferred shares and minority interests plus cash and cash equivalents. Enterprise value is commonly used when comparing companies in the same industry and is the primary driver behind valuation multiples like EBITDA/EV and EV/Sales.
Large corporations and investors looking to take over a new company rely on EV as it provides a comprehensive, theoretical calculation of a business’s worth in the market. It also has a few major differences from market cap, which is that it’s not subject to fluctuations in trading trends.
In addition, market cap is typically used for categorizing companies into brackets like small-cap or mid-cap, EV isn’t. However, both can provide valuable information for entrepreneurs and investors in assessing the potential of a business to expand its reach in the marketplace. Enterprise value will ultimately help investors to identify risks like debt in relation to the cash available. It will also reveal a company’s ability to generate profits in relation to the capital in the bank. This is particularly important when a company has an enormous amount of debt to equity.
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