What’s the value of a company? The answer to that question can differ dramatically, depending on the exact definition of “value” that investors use. In many cases, the stated value of a business varies based on the perspective from which a firm can be looked at. Because of that, nailing down the characteristics and differences between terms like enterprise value or book value would be crucial to further deepen our understanding within the finance and investing world.
The Difference Between Book Value and Enterprise Value
The book value of a business reflects the theoretical net worth of its assets according to the accounting figures stated on the balance sheet. The enterprise value, on the other hand, represents a company’s value according to the price that investors set out on the market while additionally accounting for the amount of debt and cash that is within the business.
A company’s enterprise value will most likely be substantially higher than its corresponding book value. This makes intuitive sense: To figure out how much should be paid for a business, investors aren’t just considering what the accounting value of a company’s assets are, but also look at many other factors such as
- how much the business could potentially grow (and how much it needs to reinvest for that growth)
- how efficiently it can convert revenues into cash flows
- how much risk it involves
All these aspects contribute to a much higher premium that investors are willing to pay over a company’s book value.
Here is a quick overview, comparing the definitions between book value, market value, and enterprise value:
Book Value/Equity Value
Book value of equity as stated on the company’s balance sheet
Market Value/Market Capitalization
Market value of a company’s equity, based on the market’s set stock price
Market value + debt – cash
What’s Book Value?
Book value represents exactly what the name implies: the value of something according to its “books”. The “books” in our case, include the financial statements of a business such as the income statement, or the balance sheet.
The balance sheet lists out the stuff that a company owns vs the stuff that it owes to others. If we take a closer look at a balance sheet’s structure we can figure out a pretty intuitive way to determine how much a business is worth: By subtracting the total liabilities of the company from its total assets, we would arrive at what’s called a firm’s equity. That number is what people refer to as the book value of a company:
Many investors also like to talk about the book value on a per-share basis. We can calculate the book value of a single share by dividing the company’s total book value (equity) by the number of shares outstanding:
The book value can be a useful accounting measure if we try to gauge a company’s value, for instance, with the price-to-book ratio, (divide the current stock price by the book value per share).
Even if a company’s book value can become quite useful in a number of different situations, it will very likely not reflect the “real” company value in most cases. That being said, there are some companies that do appear to have a book value that is higher than the current market value, potentially indicating that they are undervalued.
Some investors try to actively look for such companies. Deep value investors, for instance, focus on companies that are trading at a price-to-book ratio of below 1 and try to assess whether they really found an undervalued business or that is trading at such a low price for a reason.
What’s Enterprise Value?
The enterprise value is often referred to as the theoretical acquisition cost of a company. That is because it doesn’t only reflect what value the market is currently attaching to a business but additionally takes into consideration how much cash and debt the business has:
Many investors and analysts prefer to use the enterprise value as a more accurate measure of a company’s current value than purely its market capitalization. This is because of the fact that if we would acquire the whole company by purchasing all outstanding shares, we also would have the option to use the amount of cash that is within the company to pay down all its current debt.
You could view the enterprise value as a more realistic modification of market capitalization, especially when we talk about acquisitions.
The market capitalization (also known as market value), represents what a company’s equity would be currently worth on the market (as opposed to the book value of equity).
That being said, there are several other areas where enterprise value can play an important role as well. For example, when discounting the free cash flows to the firm (FCFF) within a DCF model, what we would come up with is the enterprise value. Besides that, EV is also often used as a component in various pricing metrics, a well-known example being the EV/EBITDA ratio, which can act as a potentially more insightful alternative than the popular P/E ratio.
There is a clear difference between a company’s book value and its corresponding market value: The book value of a company represents its equity value stated on the most recent balance sheet, whereas the market capitalization/market value represents what investors are currently willing to pay for that equity on the market.
The enterprise value can be somewhat viewed as a modification of market value because it additionally takes the net effect of debt and cash into consideration.