While buying anything in the market, we try to value the commodity or buying article keeping its usage, characteristics, substitute and other key factors in mind.
In the same way, while investing in any company for long term, we value the firm keeping key financial ratios, its competitive advantage, future plans, products and services of the company in mind. To come down to a fair value to pay for buying a certain portion of the firm. By valuing a company,an investor is in a position to make a better decision. As it helps to take an important decision, thus it is very crucial to arrive at the right value of the firm by using right metrics.
While valuing any firm, we mostly talk about market capitalization or market value. But this is certainly not the only way to value a company other metric too often used is enterprise value.
Market capitalization is the easiest way to calculate the value of the firm. Market capitalization is computed simply by multiplying market price of a share to the no. of share outstanding of the firm. Calculation being easy makes it favorite among investor, on top it is easy to understand, thus many investor doesn’t try to look beyond the market capitalization. Market cap doesn’t show the real picture of any firm.
Looking at the enterprise value, market cap is the starting point of the metrics. Enterprise values goes a step ahead to explain and compute the value of the firm.
Modigilani miller proved, Debt increases the value of the firm. It is true due to tax implication of debt. So debt increases the value of the firm. Enterprise value is calculated using market capitalization plus debt balances minus cash on hand and marketable securities. Thus additional debt increases the value of debt and the higher the cash in hand the lower the value of the firm.
WHY ENTERPRISE VALUE (EV) IS BETTER?
Market capitalization values the firm entirely based on equity stock . This method is easy to compute and is helpful in finding out the size of the company, peers in the industry. On the basis of capitalization, we divide the market on the basis of large-, mid- and small-cap. Market capitalization eliminates the important aspect of the valuation, like the buyer will not be responsible for equity but also for debt.
On the other hand, EV takes into account the debt balances as well. Enterprise value aids in looking for undervalued companies, thus helping in taking the right decision by picking the right stock for value investing.
Thus while going for investment thus it is very important to do your homework well, to find the right piece of investment. Do not blindly rely on market capitalization but also go step ahead and calculate the true value of the firm, the enter the right investment.