This article explains the Enterprise Value to Assets (EV/Assets) ratio in detail. Also, we’ll learn how the ratio and its constituting metrics are calculated.
For starters, the term Enterprise Value is considered to be the acquisition price for any given business. It’s essentially the amount of money required to purchase or acquire 100 per cent of some entity after factoring its market capitalization, its debt and its cash and equivalents. Enterprise value is used for the valuation of companies in the context of M&A, stock option evaluation, stock investing, financial analysis, and other such valuation purposes. The metric is used for comparisons by financial decision-makers.
How to Calculate Enterprise Value
The formula for EV is represented as:
EV = Market Capitalization + Market Value of Debt – Cash and Cash Equivalents
Further, the extended formula can be put forward as:
EV= Market Cap. of Common shares and Preferred shares + Market Value of Debt + Minority Interest – Cash and Cash Equivalents
The concept can be better explained by comparing the enterprise values of two companies in the same sector: Company X and Company Y.
Company X has a higher Enterprise Value than Company Y, which means that Company X’s purchase price is higher than Company Y and vice versa. EV results in being negative if the company holds an abnormally high amount of cash that is not reflected in the market value of the stock and total market capitalization. Thus, the significance of Enterprise value lies in its ability to compare companies with different capital structures.
The enterprise value, or EV as seen in the above formula, is calculated by multiplying the company’s outstanding shares by the current market price of one share. The company’s total long-term and short-term debt are added, and the company’s cash and cash equivalents are further subtracted. Therefore, in simple words, EV is determined by adding market capitalization and total Debt from which all cash and cash equivalents are subtracted.
An important component of Enterprise value is Market capitalization, also referred to as Market Capitalization. This is the trading value of outstanding stocks of a listed company — it’s calculated by multiplying the share price by the total number of outstanding shares for a particular company.
For instance, A company has 1,000 shares with the price of $ 200 each.
Market capitalization = Number of shares * share price = 1,000 * $200 = $ 200,000.
This is the amount required to be paid to acquire the entire share of the company, which further, in simple words, refers to the upfront price, but not the intrinsic value, to be paid to acquire the entire company.
Why Is Enterprise Value Important?
Though market capitalization denotes the price required to acquire a company, the enterprise value gives a more comprehensive, reliable, and accurate representation of the company’s total value. Enterprise value represents the company’s actual value by considering both equity and Debt to get a realistic figure of the company’s true worth. EV paints a more realistic image of the business and its value by adding Debt to it, which market capitalization does not. This Enterprise value depicts how much money is required to buy an entire company. More precisely discussing, the EV calculates what theoretical takeover price is to be paid by one company to acquire another company.
Debt and cash have a traceable impact on a company’s EV. From the formula, it’s evident that debt, in turn, increases the cost of purchasing a company as it is a further liability for the acquirer and is, thus, added to the Enterprise Value calculation formula. Again, cash being an asset is what the buyer gets to keep with the firm and so is subtracted in the EV formula calculation. Further, two companies having similar market capitalizations would have different enterprise values.
For example, company Z with $6,000,000 market capitalization, $1,500,000 cash and absolutely no debt would be much cheaper to acquire than company Y with $6,000,000 of market capitalization, Debt of $ 1,500,000 and absolutely no cash.
|Company Y||Company Z|
What is EV to Assets Ratio?
The asset is technically a resource that that the company already owns, which can be used to generate future cash flows and produce a positive economic value. Assets represent the volume of ownership that can be converted into cash. It can possess a current, future, or potential economic benefit for the entity that owns it. As every cost may be variable, with present economic conditions, most businesses are running low. If a recession hits, the earnings will end up disappointing us. So, assets tend to be much more enduring and valuable in this situation. Enterprise value provides a comprehensive alternative to calculate a company’s worth than market capitalization.
The EV to Assets Ratio is a significant valuation metric. It is used for measuring the value of a company in comparison to its total assets. It is required to compare the valuation of different companies across similar stocks in the sector. It is thus an important measure for calculating the company’s worth. It is one of the most significant ratios in the case of financial parlance.
The EV to Assets ratio is represented as:
Enterprise Value (market capital + Debt + minority interest + preferred shares- cash and cash equivalents)/Assets
Market capitalization here is the value of the entire shares of the company. The total outstanding shares include all fully diluted shares, i.e. all convertible securities and options.
Minority Interest is defined as the portion of subsidiaries held by the minority shareholders. The financial results of the subsidiary or the acquired company are consolidated with the financial results of the parent or the acquiring company. It is added in the calculation since the acquiring company has consolidated financial statements with minority interests. In simple terms, it means that the parent company includes the entire revenue, expense, and cash flow in its numbers even though it does not own 100 per cent of the business. By including minority interests, the total value of the acquired company is reflected in the ratio.
Debt in this formula is the interest-bearing liabilities. It is calculated inclusive of bank loans and bonds required to be dealt with by the acquirer. It is the total amount of money owed to all banks, creditors, and other financial institutions. It decreases the estimated value of the company being acquired. The book value of Debt is used in case the market value is not known. The amount of Debt is adjusted by subtracting cash from it because, after acquiring a company, the acquirer usually uses the acquired company’s cash to pay a portion of the assumed Debt.
Preferred stocks are securities having features of both Debt and equity. These are thus known as hybrid securities. They are treated more as Debt. In an acquisition, they are typically repaid just like Debt.
Cash and cash equivalents are considered as highly liquid investments, cash in hand, cash at bank. Cash includes cash in hand and cash at the bank, whereas cash equivalents are the highly liquid assets readily converted into cash like treasury bills, money market funds etc.
For instance, a few assumed values have been taken to calculate the value of EV to Assets Ratio.
- Outstanding Shares value = $300million
- Share price as of 11/6/20 $20 million
- Market Capitalization would be calculated as = outstanding shares value x Share price = 300 x 20 =6000 million
- Short-Term Debt $31 million
- Long-Term Debt $6 million
- Therefore Total Debt would be calculated as = short term debt+ long term debt = 31+6= $37 million
- Cash and Cash Equivalents = $7 million
- Assets= $200 million
Therefore, Enterprise Value would be
EV = Market Capitalization + Total debt – Cash and Cash Equivalents = $6,000million +$37million – $7million = $3,060 million
Enterprise value to Assets ratio would be 3060/200= 15.3
Working with EV to Assets ratio, two examples have been taken of company Rex and Company Vex.
Company Vex: EV/Assets = $30million/ $20 million = 1.5 EV to Assets ratio.
Company Rex: EV/Assets = $25million/ $19 million = 1.32 EV to Assets ratio.
Therefore, a company with a low EV to Assets value (Company Rex) is a better investment than company Vex, as the former has a higher proportion of assets than the enterprise value.
What’s considered a good EV to Assets Ratio?
A high EV to Assets ratio indicates the overvaluation of the business compared to the value of its assets. In contrast, a low EV to Assets value means that the business is undervalued. This ratio comments on investment from the point of view of its capital structure. Thus, making it easier for the investors to understand the attractiveness of the face value, priced to buy its Debt if nothing else. Thus, giving an idea of the value of an investment, especially in asset-driven industries.
The EV to Assets ratio is thus more helpful in asset-driven companies and Return on asset is more or less constant. The investors get a look at the business from its capital structure. Therefore, they can analyze and understand if the face value is priced well to buy or if it is in Debt. So, these give a good value demarcation for asset driven companies. The EV by asset ratio is a critical determinant that has an immense ability to understand the worth of asset driven businesses. Though in the case of intangible assets, the assumption is the only source of determination. EV by asset ratio also acts as an indicator of the future cash flow (FCF) opportunities, and investors might find it luring to invest. It offers a unique and primarily accurate perspective of the company’s worth by considering its total assets against its actual worth. It can also be used as an appropriate analysis tool for companies, which could give a fair idea of where the company stands in its industry in terms of the company structure.
On the other hand, the EV to Assets ratio may also come with some problematic aspects. Assets can usually be defined and categorized in various ways, which can play into this figure and lead to a wrong impression of what business might be in terms of the company’s worth. Anyone with relevant experience and practical knowledge can quickly figure how assets are presented exaggeratedly or hidden when the time comes for their actual value estimation, which is generally seen for intangible assets. So, going forward with relying on EV by asset ratio is a problem in these situations. Depreciation of asset value is also a significant contributing factor which makes it questionable to depend on EV to Assets ratio.
Keeping these limitations in mind, namely, the presentation of assets in a rosy manner, or hiding of assets during valuation, or the value of depreciation which might make the accurate calculation of the ratio a controversial topic, we can still say that EV to Assets ratio can be a valuable financial metric for anyone willing to invest in a business, which is of the most significant among the other enterprise valuation multiples.