Conventional investing theory which many investors follow deals with metrics like price to earnings ratio and price-to-book ratio. However many investors have now discovered that they would be better off if they used enterprise value in these calculations. For instance, they find it far better to concentrate on enterprise value to earnings ratio and enterprise value to book ratio. They will use enterprise value instead of market cap in calculating the earnings yield and helping them to identify under priced stocks. Why is this the case?
To better understand this you first have to know how enterprise value is worked out. The formula is quite simple and involves adding total debt to the market capitalization and subtracting what is called “excess cash”. Market capitalization is obtained by multiplying the current share price with the number of shares outstanding while total debt is the sum of all the long-term and short-term debt obligations of the company. You need to have a more detailed explanation of “excess cash” because the calculation is a little more complex. The term refers to the cash the company holds in excess of what is required to meet short-term obligations. The formula looks like this: excess cash = total cash – [total current liabilities -total current non-cash assets]… If the total non-cash current assets exceed the current liabilities, you just take the cash holding as is without adjustment. The rationale for this calculation is that if you have $1000 in your pocket but have to make a mortgage payment of $500 immediately, the cash available to you for other expenses is only the difference of $500.
Now you can begin to see that enterprise value has its advantages because it punishes companies with high levels of debt and low cash balances and rewards companies with low levels of debt and high cash balances. This is as it should be because the latter category of company is intrinsically far sounder than the former category. They have the ability to withstand business or economic downturns much better as well as the freedom to reward shareholders handsomely. They also have the resources to invest in business expansion either by way of organic growth all by way of acquisitions and mergers. This kind of fundamental strength is not available to companies with high debt and low cash holdings.
Let us take the case of two companies. The company A has a price to earnings ratio of 10 while the company B has a price-earnings ratio of 5. On the face of it, company B looks much cheaper than company A. Let us also assume that A has lots of cash on hand and is debt free while B has little cash but lots of debt. If you were to recalculate your metrics based on enterprise value to earnings, you may well find that A works out to 5 while B works out to 10. This complete reversal has occurred because A is fundamentally a much better investment than B. By using enterprise value rather than traditional metrics, you would have spotted something that you may have otherwise overlooked.
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