So What Is This "Enterprise Value?"

http://classicvalueinvestors.com/i/2010/03/so-what-is-this-enterprise-value/

Many investors rely on many different metrics such as the P/E ratio, price-to-book ratio, and price-to-sales ratio to determine whether a company is trading at a cheap price. Relying on these metrics may be misleading because it may make you buy something that is not as cheap as you previously thought it was, or it may make you might miss out on a buying to purchase something that you thought was too expensive, but really was not. So what exactly is the enterprise value? It is the price that you would have to pay to acquire a company free and clear. The enterprise value should really be called enterprise price because it has nothing to do with what the company is worth.

Let’s imagine that we are buying an apartment building for \$1,000,000 that has a \$700,000 mortgage and \$300,000 in equity. In order to acquire the property free and clear, we would have to pay \$1,000,000 with our money to pay off the \$700,000 mortgage and the seller’s \$300,000 in equity. In this case, the enterprise value (or enterprise price) would equal \$1,000,000, which is equity (\$300,000) plus debt (\$700,000). In stock market terms, the \$300,000 in equity that the seller wants would be equivalent to market capitalization, which is the price per share times the number of shares outstanding. From this example, we can construct a formula for the enterprise value in the following way:

Enterprise Value = Market Value of Equity (Market Capitalization) + Debt

This formula is almost complete, but it is missing one element. Let’s reuse the same example with the apartment property but incorporate cash into it. Imagine that we are buying the same apartment building for \$1,000,000 with the same \$700,000 mortgage and \$300,000 in equity. But this time, in one of the apartment units, we find a briefcase with \$200,000 in cash. What is the enterprise value, now?

Enterprise Value = Market Value of Equity (\$300,000) + Debt (\$700,000) – Cash (\$200,000) = \$800,000

By using the equation above, we can see that the enterprise value is not \$1,000,000, but is \$800,000, because technically, we only paid \$800,000 after taking home the briefcase with \$200,000. Therefore, the formula has to be adjusted to include EXCESS cash:

Enterprise Value = Market Value of Equity + Debt – Excess Cash

Notice that I said “excess” cash. In our example, the \$200,000 is not really needed to operate the apartment building and therefore, is considered excess cash. When calculating the enterprise value, some investors use the entire cash balance that they find on the balance sheet. Using all the cash may lead to miscalculations because assuming that the company does not need to hold any cash to operate its business is not realistic. You only want to subract the cash that is truly not needed to operate the business. For example, I analyzed KSW Mechanical, whose balance sheet is shown below:

Source: KSW Mechanical 2009 10-K

To calculate the enterprise value, we need the following variables: the market value of equity, debt, and cash. The market value of equity is \$24,000 (\$24 million), which equals the March 19, 2010 closing price of \$3.84 times 6,235,125, the number of oustanding shares. The debt is \$1,112 which equals to \$1,054, the long-term mortgage, plus \$58, the current portion of the mortgage. The amount in cash is \$14,783. Without separating cash into “necessary” and “excess” portions, the enterprise value is calculated in the following manner:

Enterprise Value = \$24,000 + \$1,112 – \$14,783 = \$10,329

To figure out how much of the \$14,783 in cash is excess cash, it is useful to analyze current assets and liabilities. In our example, current assets are \$37,719 and current liabilities are \$18,632.

Source: KSW Mechanical 2009 10-K

If we subract all the cash from current assets, \$22,936 in non-cash current assets remain. When we compare this to current liabilities of \$18,632, we can conclude that we have enough current assets without cash to cover our short-term obligations under current liabilities, and therefore, none of the cash on the balance sheet is needed, and all of it can be considered excess cash. In this case, the enterprise value would be \$10,329, as was previously calculated.

However, KSW Mechanical is a special case where it would be incorrect to treat all the cash on the balance sheet as excess. The company is in the HVAC contracting business, mainly in New York. On many construction projects, the contractor is required to get bonding that guarantees that the contractor will perform the obligation as spelled out in the bond. The bonding company can be an insurance company that will stand behind the contractor. For KSW Mechanical, the ability to get bonding is everything. If the company is not able to get bonding, it cannot get contracts, especially when the client is the government. The reason why KSW Mechanical holds so much cash on its balance sheet is to show the bonding companies that they are in good shape financially so that they can get bonding. When I called the management and asked what would happen to their ability to get bonding if they paid out this cash to shareholders through dividends or buyback, I was told that their ability to get bonding would deteriorate. As a result, I do not believe that all the cash that the company carries is excess cash, because if the company did not have it, then it would not be able to get the work that is necessary to operate their business. If the entire cash balance is not excess cash, then how much of it is? It is debatable.

Conclusion

The equation for the enterprise value is straighforward as repeated below:

Enterprise Value = Market Value of Equity + Debt – Excess Cash

The important part is to plug in the correct variables to get meaningful results. Most of the time, the excess cash can be determined by comparing current assets to current liabilities, but at other times, as with the case of KSW Mechanical, a phone call to the CFO may clarify how much cash is really excess.