Market Cap vs. Enterprise Value

One of the most fundamental aspects of evaluating a stock is the market capitalisation; it represents a valuation that the market has assigned to a particular company. However, the market capitalisation of a company is not always the best figure to use when comparing; sometimes the enterprise value of a company is more appropriate. It can be defined as:

"The market capitalisation of a company, plus the value all outstanding debts (or equivalents), minus the value of all cash balances (or equivalents).
Therefore the basic enterprise value can take into account the debt levels of a business. This is crucial in performing valuation comparisons. Consider this; if Company A has a price-earnings ratio of 10 and Company B has a price-earnings ratio of 15, and both companies have a market capitalisation of £200m. You may jump to the conclusion that Company A is 'cheaper' on valuation metrics. However, if Company A has £2 billion in debt and Company B has net cash of £50m, the entire valuation comparison changes.
This does not just apply to companies where conventional valuation metrics exist either. Enterprise values can be used for resource stocks when comparing the relative value being placed by the market on resource deposits. Therefore, being able to calculate the enterprise value of a company is essential.
Before looking at an example, it's important to be able to recognise what can be classified as an equivalent to either cash of debt. These are the most common:
- Equivalents to cash: Liquid investments such as short-term treasuries/bonds/gilts or deposits
- Equivalents to debt: Bank loans, bonds, capital/finance leases, derivative liabilities
Let's look at a real life example of calculating a basic enterprise value. Just before I do that, it's worth noting that these numbers are based on the date at the end of the last reporting period; you may choose to then estimate cash burn/generation since and add that to the cash figure. For simplicity though, this example will not look at that.
Click to Enlarge
To the right is part of the balance sheet from the last half-year set of accounts for Driver Group (LSE:DRV). To calculate the enterprise value you need to know the market capitalisation, which we will take to stand at £27.75m.

There are three rows to consider, and these have all been highlighted. As per the definition earlier, you need to subtract the cash balance and add back the borrowings.

£27.75m - £1.060m + £1.016m + £1.250m = £28.96m. This is the most recent enterprise value for Driver Group.

How is this useful? One way in which this is useful in that is allows us to derive a price-earnings ratio that is adjusted for any net debt/cash balance.

Without using an enterprise value, Driver Group has a share price of 100p, has 27.75m shares in issue and has a market capitalisation of £27.75m. For 2014, Driver Group has forecast earnings per share of 8.70p. Therefore, the unadjusted price-earnings ratio is 100/8.70 = 11.49.

But we know there is a slightly higher enterprise value at £28.96m. To account for the debt, the first step is to find the new adjusted share price (i.e. a share price that is adjusted higher to add in the debt per share). We therefore divide the market cap by the number of shares in issue: 28.96/27.75 = 104.36p. This new share price tells us that debt per share stands at 4.36p. The new adjusted price-earnings ratio is therefore 104.36/8.70 = 12.00.

Thus there is a 0.51p earnings per share discrepancy between the two figures and using the enterprise value figure is more useful than the market capitalisation figure when performing comparisons.

Adjusted Enterprise Values

One argument that is often made against enterprise values is that they still do not account for the full amount of a company's current liabilities or assets. In particular, if there are a significant amount of net payables/receivables, that merits further investigation. There are therefore sometimes additional components added back or subtracted from the market cap, including pension deficits. Is these are included, we arrive at adjusted enterprise values.

In the case of Driver Group, the process is very similar to before. If we wish to also include net receivables, we take the market cap, subtract cash, add borrowings, subtract receivables (since it's an asset) and add payables.

This is the calculation: £27.75m - £1.060m + £1.016m + £1.250m - £12.634m + £6.349m = £22.67m. If we wanted to, we can now work out a further adjusted price-earnings ratio. As before, first find the new further adjusted share price: 22.67/27.75 = 81.69p. Recall the forecast earnings per share are 8.70p for 2014. Therefore the new further adjusted price-earnings ratio is 81.69/8.70 = 9.39.

There are of course further points to look at when adjusting for items that are not debt or cash. For example, if you have a large net receivables balance you should check the quality of these receivables. Receivables is essentially cash owed by third-parties; if this cash has been due for an extensive period of time, then it is possible that these payments will never be made to the company, and the receivables might need to be written down.

Even so, this process of adjusting for various items grants you additional flexibility when performing valuation comparisons.