Valuation ratios can be highly useful and provide clarity when comparing stocks across companies, industries, and other ratios. They show the relationship between the market value of a company or its equity and some other fundamental financial metric. A valuation ratio gives an investor visibility by showing the price they pay for some streams of earnings, revenues, or cash flows. One such valuation ratio discussed in this article is Enterprise Value to Market Capitalization which is also referred to as EV/Market Cap.
Also referred to as equity value, market capitalization is the number of shares outstanding multiplied by the current price per share. It refers to the worth of a company which is determined by the current market price of the shares in the stock markets. Market capitalization is one of the most important characteristics that help the investor determine the return and risks in a share perceived by the market. It also allows investors to choose the stock which meets their risk and diversification benefits.
Companies are broadly classified into the following 3 categories based on their market capitalization:
- Small Cap – $300 million to $2 billion
- Mid Cap – $2 billion USD to $10 billion
- Large Cap – $10 billion and above
Market Capitalization = Number of shares outstanding * Current market price of one share
As of September 30, 2021, Apple had 16.865 billion shares outstanding and its shares were trading at $156.8 on NASDAQ under the ticker symbol AAPL. This meant that its:
Market Capitalization = $156.8 * 16.865 billion = $2,644.4 billion.
Enterprise Value (EV)
Enterprise value is a measurement of the total value of the company, after factoring in its market capitalization, cash and cash equivalents, as well as both short-term and long-term debt. The metric essentially highlights represents the entire value of the company, if it were to be taken over by another company.
Enterprise value also takes into account the debt that the company has taken over, while market capitalization only considers equity. Therefore, Enterprise Value of a company is a much more comprehensive metric than the commonly used Market Capitalization.
Enterprise Value plays a significant role for investors to find a fair value for the company, and it helps in comparison of companies having different capital structures. Enterprise value can be used to compare the value of a company to another in the same industry. It is usually used in analyzing investments or the value of a merger, trade, or acquisitions.
Enterprise Value = Market Capitalization + Debt + Preferred Stock + Minority Interest – Cash
Cash is deducted while calculating Enterprise value as once the acquisition of some company gets completed, the cash belongs or comes in the hands of the company which acquired it.
Components of Enterprise Value
- Market Capitalization: This is the market value of a publicly-traded company’s outstanding shares. Market capitalization is equal to the share price multiplied by the number of shares outstanding.
- Preference Stock: Even though preference stock has the term stock in it, it is not considered as equity, rather as debt. A preference stock issue that must be redeemed at a specific date at a particular price acts like debt. In other cases, preference shareholders may even have the right to receive a fixed dividend and a portion of profits. Preference stock dividends are paid out to shareholders before common stock dividends are issued. If the company files for bankruptcy, the preference stockholders are entitled to be paid from the company assets even before the common stockholders. It’s important to note that preference shareholders usually have no or limited voting rights in corporate governance. Since capital is also contributed by preference shareholders, it is significant to include its value while determining the overall acquisition cost of the company.
- Long-term and Short-term Debt: Debt is a liability that a company incurs when running its business. Total debt is the sum of all long-term liabilities and is identified on the company balance sheet. Liabilities can be broken down into short-term (current) and long-term (non-current) obligations. Short-term obligations need to be fulfilled in the near future and within 12 months, whereas long-term liabilities are obligations with payment beyond the 12-month time frame.Debt gives an advantage of tax shield and is often used by companies to lower their cost of capital. But rising debt conditions in an organization must be analyzed carefully as it can lead to credit risk and lower ratings. Involvement of debt in the capital structure requires regular cash flow for fixed interest payment obligations, and eventually, the principal amount. In a crisis like the Covid-19 pandemic, the firm may find it difficult to service its debt obligations and eventually run into bankruptcy. When a company is taken over, the buyer also acquires the debt of the firm.
- Minority Interest: Minority Interest or non-controlling Interest is the ownership stake of less than 50% in a company. It can either be stock ownership or a partnership in the company. Minority Interest is treated as a non-current liability on the balance sheet of the companies with a major stake in the company. It represents the proportion of its subsidiary owned by the minority shareholders.Suppose Company X acquires controlling interest of 70% in Company Y, and the remaining 30% remains with Company Y. Company X in its financial statements cannot claim the entire value of Company Y without accounting for the 30% that belongs to the minority shareholders of Company Y. Thus, Company X must adjust the impact of Company Y’s minority interest on its balance sheet and other financial statements.
What Is Enterprise Value to Market Cap. Ratio?
The Enterprise Value to Market Cap ratio gives a quick glimpse into the company’s capital structure. Enterprise Value on its own, is comprised of market capitalization and market value of debt, without the contribution of cash and cash equivalents. But just looking at the Enterprise Value figure doesn’t tell us how much of it is debt, cash or market cap. So, we divide Enterprise Value by Market Capitalization, to get a quick glimpse of roughly what the EV is comprised of.
A higher EV to Market Capitalization ratio is generally not preferred. It means that the firm has an Enterprise value greater than the Market capitalization, or in other words, that the company high levels of debt and preference shares. Such firms are deemed risky. A lower EV to Market Capitalization ratio, on the other hand, is more favorable as that would mean that the firm has low debt levels and is, in turn, considered a relatively safer investment.
- It’s not a very good metric to compare valuations across different companies.
- It doesn’t factor in growth rates of the company.
- A low EV/Market Capitalization figure, on its own, doesn’t always indicate a company is healthy. Maybe the concerned company’s free cash flows are shrinking, rendering it incapable of repaying its debt.
Companies with identical market capitalizations can have radically different enterprise values. Company A may have considerable debt and little cash, while Company B might have no debt and considerable cash.
|Market Capitalization||Debt||Cash||Enterprise Value|
|Company A||$7 billion||$5 billion||$1 billion||$11 billion|
|Company B||$7 billion||–||2 billion||$5 billion|
Both companies have a $7 billion market capitalization, but Company A has an Enterprise Value of $11 billion and Company B an Enterprise Value of $5 billion. When comparing Company A to Company B, company A is riskier than company B (everything else being equal) because it has a high amount of debt. Also, company A would have to provide a much higher return in dollars to compensate for its high value and greater risk.
The Enterprise Value to Market Cap Ratio
The Enterprise Value to Market Cap ratio offers a quick way to compare capital structures across different companies. It doesn’t replace the due diligence process or the need to build financial models, before investing. It is, at best, a good metric to screen from thousands of stocks before taking a deeper analytical dive into the concerned company.