For example, recent move in General Electric stock showed how only looking at its market capitalization was misleading.

In recent years, companies (not all) took benefit from a low yield environment to leverage their balance sheets for share buybacks, dividends, even sometimes acquisitions… Enterprise Value is essential when analyzing a company.

Debt matters and Enterprise Value helps.

Let’s start with an example with 2 friends net worth.

To make it practical, we will include House price, Mortgage and Cash:

By only looking at house price, you would/could think that Andrew net worth is higher than John’s, even x2 bigger: 1m vs 500k.

But as we all know, a mortgage is simply the money we owe to the bank and as long as we have not pay back the mortgage, we do not strictly own the asset.

After including debt and cash, we have:

John’s net worth = 500k -50k + 150k = 600k

Andrew’s net worth = 1m – 750k + 50k = 300k

Where John’s net worth is x2 bigger than Andrew’s.

Now let’s look at 2 companies in the same sector and same industry:

HBI = Hanesbrands which manufactures and sells apparels and clothing products

and

RL = Ralph Lauren with very similar activities.

To make it easy we will include market cap (share outstanding x price per share),

By only looking at market cap., HBI looks “smaller” than RL by 3.4bn and/or 33% “smaller”.

But then let’s look at where is the market consensus for 2019e Income Statement:

So, how come HBI and RL have pretty similar Sales-EBITDA-EBIT-Net Income numbers but HBI market capitalization is 33% smaller than RL?

Intuitively we could start to understand that only looking at market capitalization is not good enough, that something is missing.

In fact, only looking at Market Capitalization does not reflect the capital structure of the company. That only gives us the Equity part.

To be more accurate, to measure the Total Value of a company we need to take into accounts its debt and/or cash or all the assets needed for revenues and results.

This is the Enterprise Value (EV):

EV = Market Cap. + Debt – Cash (short version)

Or

EV = Market Cap. (common + preferred shares) + debt + minority interest – cash and equivalents

That gives us for our 2 companies:

EV (HBI) = 6.4 + 3.5 – 0 = 9.9bn

EV (RL) = 9.8 + 0 -1.1 = 8.7bn

By looking at the Enterprise Value and not only the Market Capitalization, we can more accurately look at the return on assets or what assets are needed for its activity.

Let’s continue with our previous companies and look at the Income Statement:

Even if the ratios are not perfectly equal, they are much closer.

As a conclusion, looking at market capitalization could be helpful to classify companies into small, large and big companies. Nonetheless, this metric for a company analysis is too simplistic and we need to use its Enterprise Value.

To get a better and realistic picture of the company’s value, looking at Enterprise Value is more efficient. Then by getting EV, you will be able to look at all those ratios and do a real sector/industry analysis. In fact, most sector analysis and/or peer analysis are based on EV ratios.

I hope it helps,
Gregoire