Math. The four-letter word you can say on TV, yet so reviled that people go great lengths to avoid it, even when they know that doing so puts their financial well-being in peril.
Wait! Don't click away. Today brings Part 3 in a continuing series that spotlights the major computations found here at AOL DailyFinance. Or as we'll call it, a short course in Mathanese -- aka the numbers behind investing's (and life's) big equations.
Don't worry. There's nothing too complicated here. Despite how difficult and intimidating professional money managers and Wall Street talking heads make it seem, we're talking about math most 10-year-olds have learned upon graduating fifth grade. And today, it's all about market cap and enterprise value.
Would You Buy This Whole Company?
Top stock picker and Berkshire Hathaway (BRK-A) (BRK-B) Chairman Warren Buffett has famously counseled investors to consider whether they'd purchase the entire business when contemplating a stock buy. Why? A stock represents a single share in a business. If the overall business isn't attractively priced, the stock won't be either.
There are two ways to determine the overall value of a publicly traded entity:
- Market capitalization (or "market cap") defines the value of all the outstanding shares in a business.
- Enterprise value specifies the cost of buying a business outright, and as such combines the equity (i.e., stock) value with cash and debt.
Figuring market cap and enterprise value is akin to taking a look under the hood before buying a used car.
Say you like that Wal-Mart's (WMT) P/E ratio is less than 11, yet also feel compelled to heed Buffett's advice and price out the entire business. Here's the math for market cap:
[Current price per share * total shares outstanding]
And here's the equation when you plug in the numbers: [$50.28 * 3.45 billion] = $173 billion
Here's the math for enterprise value:
[Market cap - cash and equivalents + debt]
And here's the equation when you plug in the numbers: [$173 billion - $8.1 billion + $57.1 billion] = $222 billion
Why You Need To Run These Numbers
Both market cap and enterprise value have their uses, but remember that they don't say the same thing. Market cap is merely a measure of the outstanding equity, or the price to get a 100% claim on earnings. Enterprise value figures the cost of buying out both the equity and bondholders, since it adds debt into the equation.
Sure, it seems like a steal to buy Delta Air Lines (DAL) for $6.4 billion in market cap when the business produces $33.6 billion in annual revenue. Figure enterprise value, and you'll see the $14.7 billion in debt that comes with buying a claim on the airline's earnings.
Have questions or comments? Send Tim an email.
Fool contributor Tim Beyers is a member of the Motley Fool Rule Breakers stock-picking team. He owned shares of Berkshire Hathaway at the time of publication. Check out Tim's portfolio holdings and Foolish writings, or connect with him on Google+ or Twitter, where he goes by @milehighfool. The Motley Fool owns shares of Wal-Mart and Berkshire Hathaway. Motley Fool newsletter services have recommended buying shares of Berkshire Hathaway and Wal-Mart as well as creating a diagonal call position in Wal-Mart.