This makes ‘EV’, or to give it its full title, enterprise value, all the more surprising.
This is a rare concept in that it is simple, well thought out and genuinely useful – qualities that are lacking from most financial lingo.
Enterprise value is a self-explanatory term: it gives a value for the whole of an enterprise.
The key concept to grasp is that this is not the value of the equity, which is the ‘market capitalisation’ of a company. Instead, it takes account of the debts and cash as well.
This can make an enormous difference.
Remember the headlines after Royal Dutch Shell’s bid for BG Group? They were broadly along the lines of ‘RDS agrees to buy BG for £47bn’.
If only that were true.
The vaunted £47bn is only the value of BG’s equity. On top of this, RDS will take on an extra £10.5bn ($15.9bn) of BG’s debts. The full cost to RDS is actually BG’s enterprise value of £57.5bn: 22 per cent more than it was reported to be paying.
Now imagine BG’s £10.5bn of debt was cash instead. This would reduce the enterprise value to £36.5bn. Had this been the case, the informed comments would doubtless have been that RDS was paying only this lower number, rather than the full £47bn.
There are two ways of arriving at an enterprise value.
The quick-and-easy method or the slightly slower and more complicated one. The former is no more or less than the market capitalisation plus debt (or minus cash).
The (full and correct) latter method is the market value of common and preferred equity, plus the market value of debts, plus minority interests, minus cash and investments. It is usually just simpler to use the quick-and-dirty rule of thumb.
Enterprise value is sadly underused in financial analysis.
Let me illustrate this with a price-to-earnings (p/e) ratio example. As a previous Jargon Busting explored in greater depth, this is the price of a share divided by the amount of post-tax profits attributable to each share. It is still one of the most commonly used means of equity valuation. But it would be so much better if everyone used the EV and not the price of the equity.
Let’s take the real example of the train operator First Group to illustrate this. (I am using rounded numbers for the sake of simplicity.)
First Group’s current share price is 100p and last year the company earned 7.5p per share after tax, a p/e of 13.3.
But on top of First Group’s £1.2bn of equity, it has debt of £1.8bn and cash of £550m.
The EV is therefore £1.2bn + £1.8bn less £550m, making £2.45bn in total, or 204p per share. Thus the real, or EV-based, p/e is actually 27: more than double what we first thought.
Enterprise value is accurately named, simple, useful and underused. It may even catch on.
Jim Wood-Smith is head of research at Hawksmoor Investment Management
