Valuation metrics are used to determine the true worth of a company. Shedding light on the context of a company's share price, they help in assessing the company's investment potential.
In the previous two parts of our Valuations 101 series, we have discussed two relative valuation metrics, P/E and P/B. Unlike those two, the enterprise value approach is an absolute valuation metric and is based on the premise that both equity and debt capital of a company should be taken into account for valuing a company appropriately.
The enterprise value of a company is calculated by adding the company's market capitalisation with the book value of all its debts and then, subtracting the cash available with the company. This is done in view of the option available with an acquirer wherein the cash can be used to pay off the company's debts to that extent. For example, if a company has a market capitalisation of 1,000 crore and a debt of 5,000 crore, along with cash amounting to 600 crore, then its enterprise value is 5,400 crore.
By taking a company's debt burden into consideration, enterprise value gives a complete picture of the true ownership cost of the company to a potential acquirer. Hence, this metric is commonly used during mergers and acquisitions.
Another advantage is that this metric can be used for both loss-making companies and companies with a negative net worth (major shortcomings of P/E and P/B ratios, respectively).
And finally, in this metric, there is very little scope for the management's accounting manipulation, as the book value of debt and the cash on hand is easily verifiable.
A shortcoming of this approach is that it does not consider the earnings potential of capital investments, thereby making it difficult to compare companies in industries which have different margins or companies in different phases of growth.
Also, since it fails to recognise the realisable value of assets, it is an inappropriate metric for companies which are going to be liquidated (these companies tend to have assets that are very small in proportion to their debts).