As a recap, the market capitalization or market cap is just:
No. of shares x shares outstanding
Using a simple analogy, the price per share is the price of a slice of pizza if it is sold individually. The market capitalization is the price of the whole pizza (i.e. price of each pizza slice x total number of pizza slices).
What is Enterprise Value?
Enterprise value or EV is a measure of a company’ total value.
It is a much more accurate measure than just using the share price or market capitalization.
Enterprise value provides an even more accurate measure because it includes in the price the debt, minority interest, preferred shares and subtracts out the total cash and cash equivalents.
Honing in on the debt
Minority interest and preferred shares tend to be less significant so we are going to ignore that for now and focus on the debt and cash element.
If you were to buy 100% of any company on the market, not only would you acquire its assets but also its liabilities.
So imagine if you bought a company for $1,000 which had $500 in its bank account – naturally you would subtract that $500 from your purchase price.
Similarly, if the company had borrowed $500 from a bank, you would also add that “obligation” to the purchase price.
The case of Asian Pay Television
Ironically, businesses with more stable cash flows are normally able to leverage up their balance sheet more. They typically entice investors buy paying high dividends initially.
However, these dividends are rarely sustainable simply because of the company’s debt load.
A change in business climate will force them to divert their cash flows to paying down their debt or higher interest charges – leaving less money for dividends which was exactly the case here.
Companies that have extremely high enterprise values relative to their market caps are normally highly geared. This makes them particularly vulnerable to disruptions in their business.
Leverage magnifies outcomes. In good times, it can add a significant boost to your earnings. In bad times however, it can be devastating to the company.
Always assess the net debt position of a business – especially companies which are dividend plays to assess how sustainable the dividends are.