How is the enterprise value ( EV ) calculated? Why does it tell the truth better than market capitalization?

You bought a second-hand car for 10,000, and then found 2,000 in cash in the trunk. What is the real cost? 8,000, right—this is the core logic of Enterprise Value(Enterprise Value).

What is EV?

In simple terms, EV is about calculating the real takeover cost of a company. It's not about looking at the fluctuations in stock prices, but rather figuring out how much it would actually cost you to buy the company.

The formula is very straightforward:

EV = Market Cap + Total Debt - Cash

Why do we calculate it this way? Because:

• Debts to be added: Taking over the company means you have to pay off its debts, which is an additional cost.
• Cash to be deducted: Just like the 2k when buying a car, which can be used to offset the purchase price directly.

For example, let's take a numerical case: a company has a market value of 10 billion, owes 5 billion, and has 1 billion in cash on hand → EV = 10 + 5 - 1 = 14 billion. This is the actual takeover price.

EV vs Market Cap: Why Institutions Value EV More

Market capitalization is only seen as stock price × number of shares, which is quite one-sided. A company may have a low surface market value, but if it has mountains of debt, taking it over is actually very expensive. Conversely, a company sitting on cash has a lower real cost.

So using the valuation ratio derived from EV is more reliable:

• EV/Sales: Look at it together with comparable peers in the industry
• EV/EBITDA: The most commonly used metric, filtering out the noise from depreciation and taxes, directly assessing earning capability.
• EV/EBIT: Further simplified by excluding the impact of depreciation and amortization.

For example, EV/EBITDA=18.6, this is a bargain in the tech software sector, but it might be overvalued in retail. The key is comparing with the industry average.

The Pitfalls of EVs

There are pros and cons:

✅ Advantages: Reflects the true cost of acquisition, taking into account both debt and cash, which is more rational than simply looking at P/E.

❌ Trap：

• Didn't tell you how to use and manage debt - it's easy to be deceived just by looking at numbers.
• Capital-intensive industries should be cautious (manufacturing, oil and gas, etc.) — EV may be inflated, which could mislead you into thinking it's cheap.

So always remember: Looking at EV alone can lead to failure; it must be benchmarked against the industry average.

Finally

EV is not omnipotent, but it is much clearer than market value dimensions. Especially when mining undervalued stocks, using the EV series of indicators can reveal opportunities that the market has not seen. But the premise is not to be misled by the high capital cost characteristics of the industry.