Why Some Investors Evaluate a Stock Using Enterprise Value vs. Market Cap
Stock selection between different companies is always an apples to oranges comparison – even when the companies are in the same industry. But uncovering comparative value among the universe of stocks and other investment options is fundamental to successful investing. So successful stock market investors must sift for certain criteria, these filters are often financial measures. While data such as Earnings Per Share and P/E ratio get a lot of attention, other metrics may help investors sort and filter to create their watch list, as some companies move toward the investor’s buy list. One of these is Enterprise Value in comparison to Market Capitalization.
Understanding Enterprise Value
Enterprise value (EV) is the total value of a company, defined in terms of its financing. It includes the current market capitalization (share price x shares outstanding) and compares it to the cost to pay off debt, then adds in asset values. The below calculation results in establishing the company’s enterprise value, indicating what one might think should be the minimum needed to buy the company.
EV=Market Cap+Debt-Cash
The result can be thought of as the potential cost to acquire a business based on the company’s capital structure. As a concept, enterprise value gives you a realistic starting point for what one would need to spend to acquire a public company outright. In reality, it typically takes a premium to EV for an acquisition offer to be accepted.
Trading Below Enterprise Value
When a company is trading below its enterprise value, it suggests that the market is valuing the company at a price lower than what its underlying assets would be worth if sold separately. In some circumstances, This situation presents investors with potential opportunities and indicates that further research and investigation may be prudent.
A popular example of a company that has traded below EV, or less than the net of its assets and debt, is Apple. The company has had on its books massive amounts of cash, along with longer-term assets, the value less any debt is higher than the market cap (Outstanding Shares x Price Per Share).
Looking for Potential Buys
There are times when it may be worth considering an investment in a company that is trading below its enterprise value:
Temporary Market Pessimism: Companies may experience short-term setbacks, negative market sentiment, or sector-wide pessimism that leads to their stock price trading below enterprise value. It is important to assess whether the company’s fundamental strengths remain intact despite these challenges. If the negative sentiment appears temporary and the company is expected to rebound, it could be a window of opportunity.
Mispricing and Market Inefficiencies: The stock market is less than perfectly efficient, and mispricings do occur. Investors who identify stocks trading below enterprise value due to market inefficiencies can potentially capitalize on these pricing discrepancies. The investor may have to roll up their sleeves to do more analysis to determine whether the undervaluation is based on actual fundamental weaknesses or if it is a result of temporary market inefficiencies.
Asset-Rich Companies: Companies with significant tangible or intangible assets, such as real estate, patents, or intellectual property, may trade below enterprise value. Investors may find these stocks attractive as the underlying assets can provide a margin of safety and potential upside. Assessing the value and potential monetization of these assets is crucial before considering an investment.
In the case of Apple above, cash is easier to evaluate than real estate, patents, or other assets.
Considering Sellling
While stocks trading below enterprise value can present attractive opportunities, there are circumstances when it may be wise to consider selling.
Fundamental Deterioration: If a company’s underlying financials are weakening, for example, declining sales, increasing debt levels, or increased costs of doing business could indicate a problem. It is important to evaluate whether the company’s operational challenges are likely to persist, as this could impact its ability to sustain value.
Industry Decline or Structural Issues: Some companies trade below enterprise value due to broader industry decline or structural issues specific to the company. If the industry’s prospects are exoeriencing prolonged weakening, or the company faces inherent challenges that limit its growth potential, it may be prudent to sell the stock, even if it appears undervalued based on enterprise value alone.
Take Away
Understanding enterprise value and using it while sifting through opportunities could help bring stocks to the surface that one may not have considered.
Using EV as an evaluation tool is not a slam dunk, if investing was that easy we’d all be wealthier. However it is a good starting point to isolate stocks and then evaluate why they may be trading below EV. Is it warranted, is it unwarranted?
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Managing Editor, Channelchek
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