Here’s where the ‘legendary’ concept of Enterprise Value comes in. We’ll learn about how it is calculated, what are the nuances of the formula and how it can be used. In other words, we’ll try to answer the question: What would it cost to buy/sell this business free of its debt and other liabilities?
Enterprise Value (EV), also known as Transaction Value, Firm Value or Takeover Value/Price - is a key capital structure neutral metric used for calculating a more accurate market/economic value/price of the business, since it considers other factors such as the debt and cash position of the company. It is nothing but a modification of (or alternative to) Market Capitalization (MCap) or as we call it in the private equity world - Equity Value (QV).
Without getting into technicalities (of options, black-scholes etc) we can safely consider MCap and QV as the same. However, from a mergers and acquisitions academic perspective, QV incorporates all equity interests in a firm whereas MCap or market value only reflects those common shares currently outstanding. (Debate aside!)
Before you try to understand EV, you need to understand MCap/QV, Debt and Cash. But let’s start with this slightly detailed formula:
Enterprise Value = Equity Value (or MCap) + debt, if any + minority interest, if any + preferred equity, if any - associate company, if any - cash and cash-equivalents.
Note the following:
· Each component in the above formula is market value (not book value).
· Value of minority interest is added because it reflects the claim on assets consolidated into the company.
· Value of associate companies is subtracted because it reflects the claim on assets consolidated into other companies.
What is Equity Value/Market Capitalization? And why won’t it work by itself…
MCap, is nothing but the current stock market price multiplied by the number of shares outstanding. It also serves as a company’s price tag. But MCap ignores debt, which if substantial enough - can change the picture significantly. So in order to adjust this factor, we estimate the Enterprise Value - by adding the debt to the MCap and subtracting cash (more on cash and debt adjustments below).
Why are debt and cash considered in valuing a firm?
If the company is sold to a new owner, the buyer has to pay the Equity Value (in acquisitions, this price is typically set higher than the market price) and must also repay the company’s debts. Of course, the buyer gets to keep the cash available in the company (on its balance sheet), which is why cash needs to be deducted from the company’s price (as represented by MCap).
Why is Debt added?
Once you’ve acquired a business and have full ownership of the company, you’ve also acquired its debt (if any) and cash. Ideally you will be required to pay this off. Remember, we’re trying to calculate EV - a better estimate of value, so add back the debt (including long and short-term debt reported in the balance sheet) to the MCap/QV and subtract cash (more on this below). So, even if two companies have equal MCaps, the company with debt (or if more debt is added) is valued/worth/priced more.
Why is Cash subtracted?
I’ll repeat: once you’ve acquired/purchased/bought a business and have complete ownership of the company, you’ve not only acquired its debt (if any) but you also acquire the cash sitting on the balance sheet (or in the bank) - with this cash, you can either pay down the debt (if any) or pay yourself a dividend! By paying yourself a dividend, you’re effectively reducing your purchase/acquisition price i.e. the company was only worth the reduced amount to start with. For this reason, it is subtracted from the MCap/QV when calculating Enterprise Value. So, even if two companies have equal MCaps, the company with more cash (or if more cash is added) is valued/worth/priced less.
So if there is too much cash in the company, the Enterprise Value can be negative - and in fact I know a few friends, particularly those that follow the value investing philosophy, who actually run stock screens to find such value companies i.e. companies that are generating a lot of cash flow in relation to the Enterprise Value. Companies that fall into this category are least likely to require additional reinvestment; rather, the owners can take the profit out of the business and spend it or put it into other investments.
Why are Non Operational Assets (NOA) subtracted?
Just as in the case of cash above, in your acquisition, you may also acquire assets in real estate or stocks or other liquid investments/marketable securities that may not in anyway be related to the business or hurt the performance of the business, but act as a source of liquidity. By reducing the NOA from the MCap - you’re effectively increasing your cash position or in another way decreasing your debt position.
Why is Preferred Stock added?
Although it is technically equity, preferred stock can actually act as either equity or debt, depending upon the nature of the individual issue. A preferred issue that must be redeemed at a certain date at a certain price is, for all intents and purposes, debt. Preferred stocks may also have the right to receive a fixed dividend plus share in a portion of the profits. Regardless, the existence represents a claim on the business that must be factored into Enterprise Value. Preferred stock and convertibles that pay interest should also be considered debt for purposes of calculating value.
What is Net Debt (Net Cash)?
We just discussed the reasons for adding debt and reducing cash. In short, we call this Net Debt (i.e. net effect). So Net Debt = Debt - Cash. If you know a bit of maths, you can put this into our equation. But remember, you have to ADD Net Debt so as to maintain the signs.
EV = MCap + Debt - CashEV = MCap + (Debt - Cash)EV = MCap + Net Debt[OR] EV = QV + Net Debt[OR] QV = EV - Net Debt[OR] QV = EV - Debt + Cash (learn the maths buddy!)Note the following:§ Now think, what happens if you have more cash than debt? The Net Debt will show up as negative or what I often call a ‘Net Cash’ position. Remember, you ADD Net Debt, so if its a negative, you’re basically subtracting! Try an example right now to learn it.
Why Is Enterprise Value Important?
The value of EV lies in its ability to compare companies with different capital structures. By using Enterprise Value instead of Market Capitalization (which only represents the market’s valuation of the share holders’ claim on the assets of the company - i.e. the value of the company’s assets, net of any long-term debt) - to look at the value of a company, investors get a more accurate sense of whether or not a company is truly undervalued. A buyer may want to restructure the company’s capital, so they are more interested in the Enterprise Value rather than the Equity Value.
Enterprise Value is not a valuation, i.e. a theoretical price at which a company should trade, but a value, meaning the current or real definite price. Remember, EV is at a point in time. Although it is not 100% perfect, it is more or less accurate economic value. At the end of the day - you’re considering the MCap which is affected by the variances in the stock market (and you know how volatile that can be!).
Why go to all this trouble when some argue that the value of the stock has already been factored for the debt and cash? Because no matter how much the actual price of the stock changes, the debt and the cash do not go away. A buyer still has to take on the debt and still gets to put the cash in the bank whether the company’s stock is worth Rs1 billion or Rs1. Debt and cash are economic realities and will not disappear when you buy a company.
OK! I have an Enterprise Value - what now!?
Enterprise Value alone is not really going to help you. You need to look at things from a comparative perspective, i.e. to help you compare apples and apples - we do this by using ratios.
Just take a common ratio - EBITDA Multiple - Enterprise Value / EBITDA (Earnings Before Interest Tax Depreciation & Amortization!) to compare companies within a sector or different sectors and you’ll start to see the benefits of calculating EV over just using MCap. If we use EV in the numerator of our valuation metric, to be consistent (apples to apples) we must use a capital structure neutral (unlevered) metric in the denominator, such as Sales, EBIT or EBITDA.
We use EBITDA (and not Net Income/Profit) because we immediately pay debt and consume cash, not accounting for interest costs or interest income, and because it is the closest thing to free cash flows, which avoids any accounting distortions (heard of Andersen, Enron, Creative Accounting???).
It is important to know the difference between the enterprise value and the equity value because you need to know the right one to use when calculating given valuation multiples. If you take a quick look at a company’s income statement, scan down until you get to the line that has calculations for interest income and interest expense. Any numbers below that line are going to have multiples calculated from equity value, while any numbers above that are going to have multiples calculated off of enterprise value.
So why isn’t EV so common (yet)?
Let’s put it this way, people like the path of least resistance and MCap information is easier to find than EV. But if you’re a serious investor, or want to own a company - you definitely want to put in a few hours of effort to buy at the right price (and save a few thousands, millions or even billions), right? Sadly, the rigor of doing this puts people off! Let’s leave the gambling to casino, you’re here to do your homework*
*We call it due diligence for a reason!!
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