What is the difference between Embedded Value and Enterprise Value?

Before investing in markets, investors analyse companies based on enterprise value and sometimes, the embedded value. Find out what these values are and how can investors use them for their benefit

Nikita Vashisht New Delhi

With a flurry of initial public offers hitting the markets, it’s important for investors to pick and choose issues of fundamentally strong companies. It involves determining the economic value of a company, and assigning a value to it.

This process is known as ‘valuation’ of a company. It includes an analysis of the company’s management, its capital structure, its future earnings prospects or the market value of its assets. 

While there may be a number of valuation related terms that one can encounter, there are two terms that investors usually confuse.

These are embedded value and enterprise value. Let’s decipher both of these.

Simply put, enterprise value is the entire value of the business, without giving consideration to its capital structure.

Also known as firm value or asset value, enterprise value is the total value of the assets of the business, excluding cash.

So, if you know a firm’s equity value, as well as its total debt and cash balances, you can calculate the enterprise value via this formula.

Enterprise value is equal to equity value of a firm, plus debt, less cash component. Here, equity value is number of outstanding shares multiplied by market price of one share. EV is the price that a buyer would typically pay for buying a company. 

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During the valuation process, EV helps to enable business entity to find out the worth of a company, and also find out the economic value of the business.

Besides, it helps investors to easily compare different companies with different capital structures. Enterprise Value also helps neutralize the stock market risk and helps to compare expected returns more effectively.

Now, let us understand what is an embedded value and if it is any different from an Enterprise Value?

Unlike Enterprise Value, which can be used across sectors, Embedded Value is mostly used for life insurance companies.

The metric is used to estimate the consolidated value of shareholders' interest in an insurance company. 

The generic formula to calculate an embedded value is to add the present value of future profits of a firm to the net asset value of the firm's capital and surplus. It sometimes known as market consistent embedded value (MCEV).

The present value of future profits captures projected future profits from in-force policies, while net asset value of capital and surplus represents the funds belonging to shareholders that have been accumulated in the past. 

So, why do insurance companies use embedded value as its metric and not enterprise value?

According to valuation experts, life insurance business is very different from any other business due to the long-term mutual commitment of the customer and life insurers to each other.

Therefore, the use of traditional ratios like Price-to-Earnings or Price-to-Book Value would always make life insurance companies look overvalued.

The correct way to value a life insurance player is to value the committed business from each policyholder over the lifetime.

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