Sunday, June 20, 2010

Enterprise value is mathematically calculated as below,
Enterprise value = ( Total Market cap + Debt + other liabilities ) - ( Cash & Cash equivalents + Asset Value ).
Now what does this Enterprise Value (EV) mean? Let me try to explain in layman terms. Assume a company's market cap is 100 Rs with 0 debt and 0 liabilities. Lets say they have 10 Rs cash on their bank account and Asset Value (Property value and so on) is 30 Rs. Mathematically, their enterprise value is 60 Rs (100 - 10 - 30).
Lets say, i buy 100% stake of the company by paying 100 Rs (Market cap). For some reason, 6 months down the lane, i decide to shutdown the company. I will be left with 40 Rs (10 on Cash and 30 on asset) losing 60 Rs (EV) on the 100 Rs investment i made in buying the company.
Based on the above example, you can conclude that Enterprise Value (EV) is the risk you take in buying a company's share. If you buy a share whose EV is 0, your investment is at ZERO risk. This is ofcourse, excluding the fact that, future earnings could go into losses adding on to company's liabilities which will inturn push EV / risk higher. Thats the reason why reputed companies, with consistent revenues command higher EV. Thats the reason why Satyam's shares, dropped from 600 to 6 Rs when they confessed revenue manipulation. The reason why strong buying came back at 6 Rs, is because EV was close to 0 or even negative which made it an attractive buy. The stock rose to 20 even before Indian govt announced merger / acquisition plan. Just stressing the fact that, even when everything is lost, EV comes in to play for investors.
One other popular story is from Warren Buffett's investment in GEICO (Govt Employees Insurance Company). GEICO had somehow miscalculated the premiums on insurances and made heavy losses in financial year 1976. Share prices plummeted from 42 $ to 2 $. The company's core business was still intact. Buffett started buying at 3 $. Over the years, GEICO went from strength to strength, with Buffett always seizing the opportunity to increase the Berkshire shareholding. However, business started to drop off in the 1980s and by 1994, the share price had fallen again. Buffett grabbed his chance and bought out the other shareholders for a total price of 2.3 billion dollars. Today - GEICO's assets have reached $28 billion.