Why do we subtract cash when calculating enterprise value?
Shouldn't we be paying for the cash on hand too? If I am selling my company, why would I pay someone to take my excess cash?
Before we answer this question lets make sure understand what enterprise value is.
What is enterprise value (EV)?
Enterprise Value is a metric that attempts to reflect the current value of a firm similar to other metrics i.e. market capitalization. However, unlike market capitalization, enterprise value is calculated with debt, cash and cash equivalents. This makes enterprise value a "truer metric" than market capitalization. Additionally, enterprise value is also used in used in standard valuation multiples such as Enterprise Value-to-EBITDA.
Enterprise Value Formula
Enterprise value = market capitalization + debt - cash (cash equivalents)
Remember that market capitalization is shares outstanding x current stock price
Explaining enterprise value
You are an investor and you want to buy a publicly traded company. After calculating the market capitalization you realize you can have a more complete picture of the company value. Before buying the company you take into account the potential expense of taking on said companies debt. Obviously, this debt is must be re payed to the lender eventually. However, this company also has some cash reserves. Those cash reserves can be used to pay down the debt mentioned earlier. The difference between cash and debt is then added to market capitalization to produce the enterprise value.
enterprise value calculation example
So now that you understand the enterprise value let's take a look at a simple example of calculating EV.
Company A has a market cap of $10 and it has $5 in cash and $2 in debt. You, the astute investor that you are, want to acquire Company A. Let's pretend you can buy all the shares at the current market cap of $10.
So you bought the company for $10. So far you've spent $10. Still following?
Now you decide to pay down all of the debt, so you use $2 in cash to pay down $2 in debt. Since that cash money already resided in the corporation that you purchased, you didn't have to spend any more money out of your own pocket to pay down the debt. You've still spent just $10.
Now you decide to pay yourself a dividend with the remaining $3 in cash on the company's books. So you pay yourself a $3 dividend. Let me add that you did all of this -- paying down the debt and paying the dividend -- on the same day that you bought the company. So now that you receive $3 in cash, you can subtract that from your purchase price. $10 - $3 = $7 (you can check this math on a calculator). So, your effective purchase price is Market Cap + Debt - Cash, or $7.
Come up with your own simple way to apply this formula. You can throw around as many numbers as you'd like. To really anchor this idea down you have to have an intuitive understanding of the formula. If your still having trouble take a look at the video below.