Enterprise Value
Determining the Takeover Value of a Company
If you frequently read financial magazines, newspapers, and annual reports, you have no doubt come across something called enterprise value. You may have wondered what it is, how it’s calculated, and why it’s so important.
What is Enterprise Value?
Enterprise value is a figure that, in theory, represents the entire cost of a company if someone were to acquire it. Enterprise value is a more accurate estimate of takeover cost than market capitalization because it takes includes a number of important factors such as preferred stock, debt, and cash reserves that are excluded from the latter metric.
How is Enterprise Value Calculated?
Enterprise value is calculated by adding a corporation’s market capitalization, preferred stock, and outstanding debt together and then subtracting out the cash and cash equivalents found on the balance sheet. (In other words, enterprise value is what it would cost you to buy every single share of a company’s common stock, preferred stock, and outstanding debt. The reason the cash is subtracted is simple: once you have acquired complete ownership of the company, the cash becomes yours). Let’s examine each of these components individually, as well as the reasons they are included in the calculation of enterprise value:Market Capitalization: Frequently called “market cap”, market capitalization is calculated by taking the number of outstanding shares of common stock multiplied by the current price-per-share. If, for example, Billy Bob’s Tire Company had 1 million shares of stock outstanding and the current stock price was $50 per share, the company’s market capitalization would be $50 million (1 million shares x $50 per share = $50 million market cap).
Preferred Stock: Although it is technically equity, preferred stock can actually act as either equity or debt, depending upon the nature of the individual issue. A preferred issue that must be redeemed at a certain date at a certain price is, for all intents and purposes, debt. In other cases, preferred stock may have the right to receive a fixed dividend plus share in a portion of the profits (this type is known as “participating”). Regardless, the existence represents a claim on the business that must be factored into enterprise value.
Debt: Once you’ve acquired a business, you’ve also acquired its debt. If you purchased all of the outstanding shares of a chain of ice cream stores for $10 million (the market capitalization), yet the business had $5 million in debt, you would actually have expended $15 million; $10 million may have come out of your pocket today, but you are now responsible for repaying the $5 million debt out of the cash flow of the business – cash flow that otherwise could have gone to other things.
Cash and Cash Equivalents: Once you’ve purchased a business, you own the cash that is sitting in the bank. After acquiring complete ownership, you can simply take this cash and put it in your pocket, replacing some of the money you expended to buy the business. In effect, it serves to reduce your acquisition price; for that reason, it is subtracted from the other components when calculating enterprise value.
Why Is Enterprise Value Important?
Some investors, particularly those that follow a value philosophy, will look for companies that are generating a lot of cash flow in relation to enterprise value. Businesses that tend to fall into this category are more likely to require little additional reinvestment; instead, the owners can take the profit out of the business and spend it or put it into other investments.Return on Equity - The DuPont Model
Analyzing the Three Components of Return on Equity
As you learned in the investing lessons, return on equity (ROE) is one of the most important indicators of a firm’s profitability and potential growth. Companies that boast a high return on equity with little or no debt are able to grow without large capital expenditures, allowing the owners of the business to withdrawal cash and reinvest it elsewhere. Many investors fail to realize, however, that two companies can have the same return on equity, yet one can be a much better business.For that reason, according to CFO Magazine, a finance executive at E.I. du Pont de Nemours and Co., of Wilmington, Delaware, created the DuPont system of financial analysis in 1919. That system is used around the world today and will serve as the basis of our examination of components that make up return on equity.
Composition of Return on Equity using the DuPont Model
There are three components in the calculation of return on equity using the traditional DuPont model; the net profit margin, asset turnover, and the equity multiplier. By examining each input individually, we can discover the sources of a company's return on equity and compare it to its competitors.
Net Profit Margin
The net profit margin is simply the after-tax profit a company generated for each dollar of revenue. Net profit margins vary across industries, making it important to compare a potential investment against its competitors. Although the general rule-of-thumb is that a higher net profit margin is preferable, it is not uncommon for management to purposely lower the net profit margin in a bid to attract higher sales. This low-cost, high-volume approach has turned companies such as Wal-Mart and Nebraska Furniture Mart into veritable behemoths.There are two ways to calculate net profit margin (for more information and examples of each, see Analyzing an Income Statement):
- Net Income ÷ Revenue
- Net Income + Minority Interest + Tax-Adjusted Interest ÷ Revenue.
Whichever equation you choose, think of the net profit margin as a safety cushion; the lower the margin, the less room for error. A business with 1% margins has no room for flawed execution. Small miscalculations on management’s part could lead to tremendous losses with little or no warning.
Asset Turnover
The asset turnover ratio is a measure of how effectively a company converts its assets into sales. It is calculated as follows:
- Asset Turnover = Revenue ÷ Assets
The asset turnover ratio tends to be inversely related to the net profit margin; i.e., the higher the net profit margin, the lower the asset turnover. The result is that the investor can compare companies using different models (low-profit, high-volume vs. high-profit, low-volume) and determine which one is the more attractive business.
Equity Multiplier
It is possible for a company with terrible sales and margins to take on excessive debt and artificially increase its return on equity. The equity multiplier, a measure of financial leverage, allows the investor to see what portion of the return on equity is the result of debt. The equity multiplier is calculated as follows:
- Equity Multiplier = Assets ÷ Shareholders’ Equity.
Calculation of Return on Equity
To calculate the return on equity using the DuPont model, simply multiply the three components (net profit margin, asset turnover, and equity multiplier.)
- Return on Equity = (Net Profit Margin) (Asset Turnover) (Equity Multiplier).
Pepsico
To help you see the numbers in action, I’ll walk you through the calculation of return on equity using figures from Pesico’s 2004 annual report. The key figures I’ve taken from the financial statements are (in millions):
- Revenue: $29,261
- Net Income: $4,212
- Assets: $27,987
- Shareholders’ Equity: $13,572
Plug these numbers into the financial ratio formulas to get our components:
Net Profit Margin: Net Income ($4,212) ÷ Revenue ($29,261) = 0.1439, or 14.39%
Asset Turnover: Revenue ($29,261) ÷ Assets ($27,987) = 1.0455
Equity Multiplier: Assets ($27,987) ÷ Shareholders’ Equity ($13,572) = 2.0621
Finally, we multiply the three components together to calculate the return on equity:
Return on Equity: (0.1439) x (1.0455) x (2.0621) = 0.3102, or 31.02%
Analyzing Your Results
A 31.02% return on equity is good in any industry. Yet, if you were to leave out the equity multiplier to see how much Pepsico would earn if it were completely debt-free, you will see that the ROE drops to 15.04%. In other words, for fiscal year 2004, 15.04% of the return on equity was due to profit margins and sales, while 15.96% was due to returns earned on the debt at work in the business. If you found a company at a comparable valuation with the same return on equity yet a higher percentage arose from internally-generated sales, it would be more attractive. Compare Pepsico to Coca-Cola on this basis, for example, and it becomes clear (especially after adjusted for stock options) that Coke is the stronger brand.Asset Turnover
The asset turnover financial ratio calculates the total sales for each dollar of asset a company owns. It measures a company's efficiency in using its assets.
http://beginnersinvestment.blogspot.com/2008/10/investing-lesson-4-analyzing-income.html
Current Ratio - Financial Ratio #2
The current ratio is one of the most famous of all financial ratios. It serves as a test of a company's financial strength and relative efficiency [i.e., does a company have too much cash on hand or not enough?]
http://beginnersinvestment.blogspot.com/2008/10/investing-lesson-3-analyzing-balance.html
Debt to Equity Ratio - Financial Ratio #3
The debt to equity financial ratio is a measure of the total debt a company owes compared to the equity of the shareholders. It tells you just how much of the capitalization is the owners vs. the creditors.
http://beginnersinvestment.blogspot.com/2008/10/investing-lesson-3-analyzing-balance.html
Gross Profit Margin Ratio - Financial Ratio #4
This financial ratio tends to remain stable over time. Significant fluctuations can be a sign of fraud or financial irregularities.
http://beginnersinvestment.blogspot.com/2008/10/investing-lesson-4-analyzing-income.html
Gross Profit - Financial Ratio #5
Gross profit is the the total revenue subtracted by the cost of generating that revenue. An investor must know a company's gross profit in order to calculate a financial ratio known as the gross profit margin.
http://beginnersinvestment.blogspot.com/2008/10/investing-lesson-4-analyzing-income.html
The interest coverage ratio has huge implications for bond and preferred stock investors in particular. This financial ratio tells the investor the number of times the earnings before interest and taxes can pay, or "cover", the interest payment the company makes on its debt.
This financial ratio tells an investor how many times a business turns its inventory over a period of time. It allows you to see if a company has too many of its assets tied up in inventory and is heading for financial trouble.
The net profit margin tells you how much money a company makes for every $1 in revenue.
The operating profit margin is a financial ratio that measures the efficiency of management.
This financial ratio is known as the quick test, acid test, or liquidity test; all mean the same thing. Of all the financial ratios, it is the most difficult and stringent measure of a company's strength and liquidity.
The receivable turns financial ratio tells you how many times a company or business collects its accounts receivable in a period of time.
Return on assets financial ratio reveals how asset intensive a business is. There are two ways to calculate ROA.
The return on equity is my favorite financial ratio. It reveals how much profit a company earned in comparison to the total amount of shareholder equity on the balance sheet. For those of you interested in long-term investing with rich rewards, companies that have high return on equity ratios can provide the biggest payoff. Read and print this article!
This financial ratio tells an investor the amount of working capital a company should keep on hand.
Working capital is perhaps more important than many of the financial ratios. It can be calculated by subtracting current liabilities from the current assets.
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