Both enterprise value and book value can be extremely useful when trying to value a stock. However, they should be used separately since they do not represent the exact same thing. When investors look at the value of a company, part of their due diligence is to look at the equity value, and also the debt and cash. This is where book value and enterprise value are very useful.
What is enterprise value (EV)?
Enterprise value represents the market capitalization of the company plus its debt and minus its cash. It simply represents the value of a business if you could own it outright, without having to pay any debt. This can be a very useful way of accessing the value of a company, and it is typically used to compare against EBITDA.
A higher enterprise value than a market cap will usually signal that the company has significant debt. This signals that the management could be trying to efficiently allocate capital, and you should always compare it with a metric of profitability, like EBITDA or free cash flow (FCF).
When looking for stocks based on EV, it is usually common to compare it with EBITDA. If the multiple is low, it signals that the stock is undervalued.
EV formula: Enterprise Value = Market cap + Long and Short Term Debt - Cash
What is book value?
Book value is stated on the company’s balance sheet, and it is calculated by subtracting the liabilities from the company’s assets. It represents the value of the company if it was liquidated today.
Traditionally book value has been used as one of the main indicators for a value stock. Value investors like Ben Graham relied on picking stocks when the price to book was below 1. Meaning that the stock was worth more than its liquidation value.
Today, price-to-book still plays an important role when valuing a company, but buying a stock just because its market cap is lower than its book value is rarely used. In fact, there are stocks with a negative book value that are extremely efficient at managing their capital. Since they can generate so much cash flow, the management will leverage the balance sheet as much as it can to generate the highest earnings and cash flow possible.
Book value formula: Book value = Assets - Liabilities
Differences between EV and book value
While book value represents the value of a stock if the company went through liquidation, the enterprise value represents the price it would cost to own a company outright, using its cash to pay for its debt.
EV is a fairer representation of the company value, because it shows the company’s efficiency, while book value is the value of the business if it closed today. Enterprise value usually tends to be higher than book value, and it is a better assessment of the overall valuation of the business.
Should you use EV or book value to value a stock?
When you are trying to value a stock, to determine whether the investment makes sense it is important to use both these ratios. You should always consider them according to the specific situation of the company while comparing it with the market cap.
A book value higher than the market cap tends to signal:
- Stock is undervalued
- Financial estimates are lower
- It’s not allocating capital efficiently
While there are some stocks trading around book value or even under that could be interesting investments, you need to ask why is it trading that low. Answering this question will help you decide whether or not to invest in the stock.
Book value reflects the value of the company’s assets and liabilities. While enterprise value gives you a better representation of the efficiency of the business. Oftentimes businesses will take on debt to create as many earnings as possible. By comparing EV with cash flow or EBITDA, you get a good sense of how well management is allocating the capital within the business.
Overall, enterprise value tends to be a better way to assess a company’s valuation, especially when compared with its earnings and cash flow. It allows investors to easily analyze the ability of the business to generate earnings over time, as well as its efficiency.
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