A Tangled Web Of Values: Enterprise Value, Firm Value, And Market Cap

Our guest blogger this week is Dr. Aswath Damodaran from the Stern School at NYU. Dr. Damodaran is a noted expert on valuation and publishes his own blog, Musings on Markets. Dr. Damodaran has published numerous articles, including his updated article on the equity risk premium. Here, he discusses the different methods of valuing a company, a shortened version of his more detailed post.

Investors, analysts, and financial journalists use different measures of value to make their investment cases, and it is not a surprise that these different value measures sometimes lead to confusion. For instance, at the peak of Apple's glory early last year, there were several articles making the point that Apple had become the most valuable company in history, using the market capitalization of the company to back the assertion. A few days ago, in a reflection of Apple's fall from grace, an article in WSJ noted that Google had exceeded Apple's value, using enterprise value as the measure of value. What are these different measures of value for the same firm? Why do they differ and what do they measure? Which one is the best measure of value?

So what are the different measures of value? The first measure is the market value of equity, which measures the difference between the market value of all assets and the market value of debt. The second measure of market value is firm value, the sum of the market value of equity and the market value of debt. The third measure of market value nets out the market value of cash & other non-operating assets from firm value to arrive at enterprise value. One of the features of enterprise value is that it is relatively immune (though not completely so) from purely financial transactions. 

Each of these measures has problems. For example, to find the market values of equity, you need updated "market" values for equity, debt and cash/non-operating assets. In practice, the only number that you can get on an updated (and current) basis for most companies is the market price of the traded shares. You also must adjust for non-traded shares, management options, and convertible securities. To get from that price to composite market values often requires assumptions and approximations, which sometimes are merited but can sometimes lead to systematic errors in value estimates. When valuing debt, you must value non-traded debt and off balance sheet debt. Even cash presents problems when dealing with operating versus non-operating cash and cash trapped offshore.

When it comes to which value estimate is the best, I am an agnostic, and I think each one carries information to investors. The PE ratio may be old fashioned, but it still is a useful measure of value for individual investors in companies, and enterprise value has its appeal in other contexts. Understanding what each value measure is capturing and being consistent in how it is computed, compared and scaled is far more important than finding the one best measure of value.