We often hear people say, "Wow, this stock is so expensive - its share price is $1,000." In reality, the stock price does not inform us of the company's value. For example, stock splits quickly lower stocks prices but have no economic significance, just like exchanging a quarter for five nickels.
In this guide, we will look at true measures of company value: market capitalization and enterprise value. We'll review how to calculate market cap and enterprise value and why these measures should be used over stock prices. These concepts are covered in more detail on the second day of our Financial Modeling course in NYC.
What is Market Capitalization and why is it important?
- Market capitalization = shares outstanding * stock price.
- It measures the total equity valuation (value to the equity holders) of a company.
- Remember, stock prices don’t mean much – a company can split or reverse split. The market capitalization is a more accurate reflection of company value than the stock price.
What is Total Enterprise Value (TEV) and why is it important?
- The abbreviated formula: Enterprise value = market capitalization + debt – cash
- The complete formula: Enterprise value = market capitalization + debt (and other liabilities including underfunded pension liability, minority interest, and preferred stock) – cash (and other excess assets including short-term securities and other excess assets not needed to run the business)
- Enterprise value tells us the value of the company to all its stakeholders, not only the equity holders.
- It is the theoretical total price an acquirer would have to pay to buy the company and settle all the claims against it (using the cash to reduce the purchase price).
- We treat other claims against the business, like preferred stock, minority interests and underfunded pension liabilities, as debt
- We treat excess assets, like investments unrelated to the business operation as cash.
- We don’t double count assets – either the asset generates cash and the value is in the cash flow, or the asset isn’t used in the business and is assumed to be sold for cash and added to the cash balance (even if it isn't ultimately sold).
What share count should I use to calculate market cap?
- Basic shares outstanding includes only the shares issued and outstanding and doesn’t include stock options or restricted stock.
- Since the restricted stock hasn’t vested yet (management usually has to either hit performance hurdles or maintain employment at the company), we don’t need to include them
- However, stock options, especially those in the money, should be included.
- The most common method is the treasury stock method
- Another method would be to use an option pricing model to value the outstanding stock options and treat that as debt when calculating enterprise value
What is the Treasury Stock Method?
- Method for accounting for the unexercised, outstanding stock options
- This method increases the share count (diluted shares outstanding)
- Add the total options outstanding that are in-the-money
- Assume the company receives cash from the exercise of those options (strike price * the number of options)
- Reduce the share count by assuming the company uses that cash to buy shares at the current market price