Market Capitalization and Enterprise Value

When you are in search for a house in a busy city like Mumbai, the asking price is often based on the market value - how much buyers are willing to pay at that particular moment in time?

But let’s say, you're considering a more complex property, you might want to know more about its true worth. For instance, you’d want to know if there are any outstanding mortgages, or what its rental income potential is. This deeper understanding is akin to how Market Capitalization (Market Cap) and Enterprise Value (EV) are used to assess a company’s true value in the financial world.

What is Market Capitalization?

Market Capitalization, or Market Cap, is the total market value of a company’s outstanding shares of stock. It’s calculated by multiplying the company’s current share price by its total number of outstanding shares. This gives a quick snapshot of the company's size and how the market values it at any given moment.

Formula: Market Capitalisation (Market Cap) = Share Price × Outstanding Shares

For example, if Reliance Industries has a share price of ₹2,000 and there are 1.2 billion shares outstanding, the market capitalization would be:

Market Cap = ₹2,000 × 1,200,000,000 = ₹2,40,00,00,00,000

Market Cap = ₹2.4 lakh crore

Market cap is often used to categorize companies into different size categories like:

• Large Cap (over ₹20,000 crore)
  

• Mid Cap (₹5,000 crore to ₹20,000 crore)
  

• Small Cap (below ₹5,000 crore)
  

What is Enterprise Value (EV)?

Enterprise Value is a more comprehensive measure of a company’s total value. Unlike market capitalization, which only considers the equity value of a company, Enterprise Value (EV) takes into account the company’s debt, cash reserves, and any minority interests. EV gives a clearer picture of what it would cost to acquire a company, as it includes both the cost of buying equity and assuming any existing liabilities.

Formula: Enterprise Value (EV) = Market Capitalisation + Debt − Cash + Minority Interest

Example:

Let’s say Infosys has:

• Market Cap = ₹5,00,000 crore
  
• Debt = ₹20,000 crore
  
• Cash = ₹10,000 crore
  

Then: Enterprise Value (EV) = ₹5,00,000 crore + ₹20,000 crore − ₹10,000 crore
Enterprise Value (EV) = ₹5,10,000 crore

The Enterprise Value of Infosys would be ₹5.1 lakh crore, reflecting not just its market price but also the net debt it carries.

Why is EV More Useful than Market Cap?

• Comprehensive: Market Cap doesn’t account for debt or cash, but EV provides a fuller picture of a company’s total value, which is crucial during acquisitions.
  

• M&A Relevance: When looking at potential acquisitions, EV is often a better indicator of the true cost to take over the business since it includes liabilities.
  

• Cash Neutralizes Debt: If a company holds significant cash reserves, its EV will be lower compared to its market cap, since the cash can be used to pay down debt.
  

Limitations of Market Cap and EV:

• Market Cap: It can be misleading for companies with high debt or low cash flow. It reflects the market’s opinion, not the company’s operational worth.
  

• EV: It doesn’t account for potential operational inefficiencies or future growth opportunities. Additionally, debt levels may fluctuate, impacting EV calculations.
  

Market Cap is frequently used to classify stocks into indices, such as the Nifty 50 or Sensex, which include only large-cap stocks. However, EV is more commonly used by investors and analysts when evaluating potential acquisition targets, especially for large conglomerates like Tata Group or Adani Group.

Market Cap and Enterprise Value give different perspectives on a company’s value. Market Cap is quick and easily accessible but can miss some important aspects like debt and cash reserves. EV, on the other hand, provides a more holistic view and is more useful in evaluating the true cost of a company in an acquisition scenario. In the next chapter, we’ll look at EBITDA and its Role in Valuation — an important metric that tells us about the core profitability of a company.