Maybe you're starting the process of selling your business, or maybe it's merely a thought in the back of your head for now. Whatever the case, you need to be up-to-date on all the relevant knowledge and terminology. This will enable you to get a fair price for the company, better inform potential buyers, and ensure that the deal goes through without a hitch.
One of the difficulties you may encounter is understanding the difference between enterprise value and market capitalization. Although both figures are used to measure the market value of a company, they're far from being the same thing. Here's a look at what differentiates the two valuations and how they both apply to the process of selling your business.
What Is Market Capitalization?
Market capitalization is perhaps the simplest way to understand the value of your company. Determining a firm's market capitalization is a matter of a quick calculation: Multiply the company's current stock price per share by the total number of outstanding shares. For example, if a company has a current share price of $20 and 1 million outstanding shares, its market capitalization is $20 million.
In many cases, market capitalization is used as an easy way to separate companies into different categories, such as large-cap, mid-cap and small-cap stocks, or to find peers in the same industry. Large-cap stocks are typically seen as less risky but lower in growth potential than their mid-cap and small-cap counterparts.
One common criticism of market capitalization as a way to measure market value is that it is too simplistic a metric. By omitting factors such as cash on hand and debt balances, market capitalization does not accurately represent how much a buyer would pay to purchase the company. For example, businesses such as General Electric require large amounts of capital that complicate the appraisal of market value.
What Is Enterprise Value?
As an alternative to market capitalization, many investors favor the use of enterprise value, a more comprehensive approach to measuring market value. To calculate enterprise value, take the company's market capitalization, add the total amount of debt obligations, and subtract the total cash on hand. Depending on the company, factors such as minority interest and preferred shares may also be added to arrive at the final number.
A company's enterprise value represents its hypothetical purchase price. The company's buyer would have to assume responsibility for all of its existing debt obligations but would also be able to pocket the cash that it gained as a result of the deal. For this reason, many people consider enterprise value to be a more accurate depiction of a company's true market value.
Enterprise value is often used in investing to differentiate companies with similar market capitalizations. Companies with smaller amounts of debt have a lower risk compared to companies with higher amounts of debt and less cash on hand. Thus, enterprise value is often considered to be a better financial metric of a company's economic value, and it is also used to calculate a number of standard ratios, such as EV/EBIT — economic value divided by earnings before interest and tax.
Knowing the difference between market capitalization and enterprise value is important for both business owners and potential buyers and investors. Depending on the situation, you should feel comfortable using and calculating both metrics to clearly demonstrate the value of your company.