Why Enterprise Value is a Better Gauge Than Market Cap

Many investors and analysts use a company’s market capitalization to measure its value. However, some would argue enterprise value is a more holistic measure of a company’s value than the market cap.

Market Cap Vs. Enterprise Value

Market cap is a simple and common way to gauge a company’s size. It’s calculated by multiplying the stock’s current share price and the number of shares outstanding.

But there are issues with this form of measurement. Market cap does not only ignore crucial details in a company’s overall valuation. It also doesn’t consider the debt or cash on its balance sheet.

Meanwhile, enterprise value incorporates a company’s entire capital structure to determine how much it would cost to acquire that business. This includes its stock market value, debt, and cash. Debt increases the cost to acquire a business, while cash lowers it.

Ignoring a company’s debt can mislead investors into thinking a stock is attractively valued. Yet once its debt is accounted for, it may no longer be as attractive.

So, a company with a strong free cash flow and large market cap may look good on paper, but if one were to calculate a company’s enterprise value, one may see serious debt obligations, which could be a problem further down the road.

A More Comprehensive Assessment

Consider a national airline carrier in the following illustrative example. If one were to look at its free cash flow relative to its market cap as of 6/16/231, they’d see a yield of 21%. However, the company is highly leveraged and once its net debt is accounted for, that yield decreases to 6%. So, measuring free cash flow relative to enterprise value may provide a more comprehensive assessment of the company’s valuation.

Free cash flow yield attempts to evaluate how much cash flow a company generates relative to the cost of acquiring that business.

“People often think of stocks as these esoteric vehicles. But at the end of the day, buying a share of stock is the same as investing in a business,” said Michael Mack, Associate Portfolio Manager, VictoryShares and Solutions. “If one were to look at investing in a business, the two questions they would ask are: how much will I pay, and what am I getting for it?”

Ultimately, enterprise value can be more comprehensive than market cap in providing a better picture of a company’s future value.

For more news, information, and strategy, visit the Free Cash Flow Channel.

1/ Source: FactSet

Enterprise Value (EV) measures a company’s total value which is calculated by taking the following aspects of a company into account; market capitalization, short-term debt, long-term debt and any cash on the company’s balance sheet.
Free cash flow (FCF) represents the cash that a company generates after accounting for cash outflows to support operations and maintain its capital assets.
Free cash flow yield is a financial solvency ratio that compares the free cash flow per share a company is expected to earn against its market value per share. It is calculated by taking the free cash flow per share divided by the current share price.

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