Enterprise Value

Enterprise Value Article

Enterprise Value Defined

Enterprise Value represents the market value of all the operating assets of the firm, regardless of how they are funded. In contrast, equity value refers to only the common equity holders’ residual stake in the value of the firm’s assets.

However, when used for valuation analysis (i.e. discounted cash flow or comparables), a company’s Enterprise Value would only reflect the cash-flow generating, operating assets of the firm. In other words, any asset that does not generate EBITDA would not be included in Enterprise Value. This exclusion is performed so that values can be compared when performing valuation analysis. For example, cash on hand does not generate any EBITDA (rather it generates interest income which is recorded lower down in the income statement), so therefore it should not be included in EBITDA. Similarly, any unconsolidated assets (such as Equity Method or other Long-term Investments) would not be included.

This does not mean that we ignore the value of these non-EBITDA generating assets when valuing a company. Rather, the value of these assets is captured when using Enterprise Value to then calculate the equity value of the firm.

The Utility of Enterprise Value

Enterprise value provides a true sense of the size and scale of a company since it includes the value of all the company’s operating assets, regardless of how they are financed. By contrast, equity value only measures the portion of the asset value accruing to the equity holders of a company. So, using Enterprise Value facilitates size comparisons as well as valuation analysis.

Using Enterprise Value as a basis for comparison separates the valuation decision from the financing decision. For example, this is how people evaluate residential real estate. They look at the Enterprise Value of the house or condo (i.e. the price in the market). Then, separately, they evaluate the financing decision which involves a down payment (equity) and arranging a suitable mortgage (debt). They are able to value the investment separately from their decision on how to finance the purchase.

In the world of Finance, asset transaction decisions come down to two major questions:

  • How much is an asset worth?; and
  • How should that asset be financed?

Enterprise Values allow finance professionals to focus on how much an asset is worth without worrying about how it is currently financed.

Enterprise Value in Ratios

Enterprise value is used in ratios for two primary purposes: (i) valuation and (ii) credit assessment.

A common valuation multiple using Enterprise Value is Enterprise Value / EBITDA, or Enterprise Value / EBITDA. Since Enterprise Value is a measure of the company’s assets, it makes sense to compare Enterprise Value to the company’s EBITDA which represents a measure of profits attributable to all capital providers. Thus, the ratio of Enterprise Value / EBITDA is consistent in that all capital providers are represented in both the numerator and the denominator. However, as mentioned earlier, it is critical that any non-EBITDA generating assets be excluded from Enterprise Value so as not to distort the multiples.

Lenders use Enterprise Values to understand what proportion of the firm’s assets are funded with debt. A common ratio (especially for more highly leveraged companies) is Total Debt / Enterprise Value. Since Enterprise Value represents the market value of the assets, this ratio gives a meaningful picture of how risky the company’s debt position is.

EBITDA Defined

EBITDA stands for earnings before interest, taxes, depreciation and amortization. It is used by the corporate finance community since it is a measure of profit that is available to all capital providers and is comparable to a company’s Enterprise Value.

We can calculate EBITDA by starting with revenue, subtracting the cost of goods sold (COGS) and subtracting the selling, general and administrative (SG&A) expenses according to the equation below:

EBITDA = Revenue - COGS – SG&A (excluding depreciation and amortization)

It is important to understand where depreciation and amortization (D&A) sits on the company’s income statement. For some companies, D&A is embedded in COGS and/or SG&A, so D&A needs to be added back separately to arrive at EBITDA – the D&A can be found in the operating section of the cash flow statement.

EBITDA is also a close proxy for cash flow which is another reason why it is helpful for those in the finance community. However, EBITDA does not take into account taxes, depreciation or amortization. These items can be significant since each company may have a completely different tax situation. Also, depending on the age of the assets that each company owns, they may have vastly different Capex profiles and depreciation amounts. Finally, EBITDA does not take into account a company’s changes in working capital which can also change significantly over certain periods of time.

Ultimately, EBITDA is used extensively in the finance industry because it is simple and easy to calculate, but practitioners should be mindful that two companies with similar EBITDA may have very different cash flows because of the items described above. The companies may therefore trade at very different EBITDA multiples because investors will factor in the differences when pricing the stock.

Calculating Enterprise Value

Since Enterprise Value is the value of all the company’s operating assets, one might think it could be calculated by individually valuing each asset on a company’s balance sheet. However, this is usually not possible because companies do not typically disclose the market values of their assets.

It is more common to calculate a company’s Enterprise Value by adding up the market value of all of the capital that is funding the company’s assets. In other words, investors in all of the capital (i.e. debt, common equity, preferred shares) of the firm expect to share in the value of the assets, so it follows that the total value of all the capital equals the value of the assets.

The basic formula for Enterprise Value is:

Enterprise Value = Market Capitalization + Total Debt + Preferred Shares – Cash & Equivalents

The market capitalization is calculated by multiplying the most recent share price times the fully diluted shares outstanding.

Of note, cash & equivalents are deducted from the calculation above because they are not operating assets and they do not generate EBITDA. Recall that Enterprise Value is the value of only the cash-flow generating operating assets of the business.

Additional adjustments may need to be made to the Enterprise Value calculation if the company has non-controlling interests or long-term investments (including equity method investments). This is because of the accounting treatment of such investments.

Debt in the Enterprise Value Calculation

Any debt that is interest-bearing (i.e. money has been lent to the company with an expectation of return) should be included in Enterprise Value. All amounts of long-term and short-term debt should be included, including current portion of long-term debt. This includes drawn revolvers, bank loans, bonds, debentures, notes etc. Leases should be included in the debt number as well since they are effectively debt on unique assets.

If a company has convertible debt, treat this as debt in the Enterprise Value calculation to the extent the security is not in-the-money. If it is in-the-money, it should be assumed to be converted into common shares and included in the market capitalization calculation. Make sure these amounts are not double-counted.

Payables of any type should not be included in total debt. Payables are liabilities, but they are not debt since they do not bear interest. The undrawn portion of a revolving line of credit should also not be included in the total debt since it is not borrowed money - only the drawn portion of a revolver should be included (the drawn portion is the amount that would be recorded on the balance sheet).

Calculating the Value of Debt and Preferred Shares in Enterprise Value

When calculating Enterprise Value, ideally we want the market values for all components of the capital structure in order to obtain an accurate proxy for the market value of the company’s operating assets. While it is easy to get the market value of the common equity (for a publicly-traded company), it can be more difficult to get market values for preferred shares and debt.

Since preferred shares often do not trade publicly, the book value will usually be sufficient. However, check to see if the preferred shares trade on an exchange.

This issue is similar for debt. Bank debt does not trade in a liquid market, so book value is almost always used. Some corporate bonds / notes do trade, so it may be possible to obtain market values.

For healthy companies, the book values for preferred shares and debt will usually be very close to the market values. So, in many cases, book value will simply be used as a proxy for market value. However, one should be cautious when using book values for a distressed company since market values of the debt will almost certainly be considerably lower than the book values.

Ultimately, when using Enterprise Value for comparables analysis, it’s important to be consistent amongst all companies in the comp set and read each company’s disclosure to look for potential issues with their debt.

Pension Liabilities and Enterprise Value

In most instances, any pension liability would not be included in the calculation of company’s Enterprise Value calculation. However, in some cases, it may be appropriate to add some portion of the liability. If a company’s pension plan is a defined benefit plan and the plan is significantly underfunded, (i.e. the value of the pension plan assets is significantly lower than the pension liability), the company may need to issue debt to top up the plan. However, an underfunded pension plan can reverse itself quickly if the value of the plan assets recovers in the future.

Making an adjustment to Enterprise Value to reflect pension liabilities is very subjective. Theoretically, the value of the operating assets should not change because of a pension obligation – rather, if the equity holders think there are new significant top up payments to be made, the value of the equity should drop (i.e. a greater portion of the value of the operating assets is now attributable to the debt holders). Therefore, to make Enterprise Value comparable across companies, one should only add back the pension deficit (or some portion of it) if one believes the company’s share price has been impaired to reflect the pension issue.

Net Debt

Net debt is defined as total debt minus cash & equivalents. Net debt is a metric often used by lenders since a company could use its cash resources to repay debt. Thus, net debt is a measure of how much debt a company would have if it used its cash to reduce the amount of debt. However, this is not really the rationale for subtracting cash in the Enterprise Value calculation. Rather, cash is deducted because it is not an EBITDA-generating operating asset.

Noncontrolling Interest and Enterprise Value

If a parent company owns between 50+% to 80% of a subsidiary, it will likely use the consolidation method to report the results of that entity – in other words all the revenues, expenses, assets and liabilities of the controlled subsidiary will be fully consolidated on the parent’s financial statements, even though the parent owns less than 100%. The remaining stake will be reported as noncontrolling interest (NCI, also called Minority Interest) on the parent’s financial statements. The value of the NCI should be added to the parent’s Enterprise Value.

It may seem counter-intuitive to then add the NCI to Enterprise Value since it is the portion that the parent does NOT own. However, when we calculate Enterprise Value, we need to include 100% of all the operating assets that the company consolidates – we therefore need to include the funding for the minority stake in the consolidated, but non-wholly owned assets (i.e. the NCI). Think of NCI as just another form of capital (in this case, third party equity instead of common or preferred equity or debt) funding the consolidated operating assets. We most often calculate Enterprise Values to make them comparable to other companies, so it makes sense to treat all companies the same with respect to accounting principles.

Another reason for adding NCI when calculating Enterprise Value is to ensure comparability when calculating Enterprise Value / EBITDA ratios. Since the parent consolidates subsidiaries for which it owns more than 50%, the parent will include 100% of the EBITDA from the subsidiary in its consolidated EBITDA. Without an NCI adjustment to Enterprise Value, the Enterprise Value will include only the portion of the equity value of the subsidiary that’s owned by the parent (since that’s what is reflected in the parent’s market capitalization) and 100% of the subsidiary’s debt (since it is consolidated on the parent’s balance sheet). Thus, to make the Enterprise Value and EBITDA comparable (i.e. the same collection of assets), we must add the NCI to the Enterprise Value.

Valuing Noncontrolling Interest for Enterprise Value

The carrying value of Noncontrolling Interests (NCI) will be shown on the parent company’s balance sheet as a separate line in the equity section. If the parent has a controlling interest in a number of non-wholly owned subsidiaries, the NCI shown on its balance sheet will reflect the combined NCI in all of these subsidiaries. The only problem is that the NCI on the parent’s balance sheet is the book value of the NCI – ideally, we want the market value of the NCI to be consistent (since we want the market values of all the pieces of capital). The share of the controlled subsidiary owned by the parent will be priced into the parent’s equity value at the assumed market value.

If the subsidiary causing the NCI is a public company (i.e. some or all of the shares held by the NCI is publicly traded), then it makes sense to use the public share price of the subsidiary to calculate the NCI for the Enterprise Value. The NCI would equal:

Market value of NCI = share price of subsidiary * shares owned by NCI shareholders

However, more often than not, NCI relates to privately-held subsidiaries. In this case, you may have to rely on the book value of the NCI, although this is not ideal since the market value could be very different from the book value. If the NCI is significant (perhaps the subsidiary is large relative to the parent), it could make sense to value the NCI using a multiple method. To do this, find an acceptable valuation multiple for the subsidiary and then calculate the resulting value of the NCI equity stake. If you use an EBITDA multiple, make sure to deduct the subsidiary’s net debt and preferred shares before calculating the value of the NCI equity.

Long-Term Investments and Enterprise Value

If a parent company owns 50% or less of another company and does not control the operations of the subsidiary, typically the subsidiary’s results will not be consolidated into the parent’s financials. Depending on the ownership level, the parent may use the Equity Method of accounting or it may simply account for the stake as an investment on the balance sheet. In either case, the stake would be categorized as a long-term investment (LTI).

When calculating the Enterprise Value of the parent, LTI is subtracted from the total. The idea is similar to the rationale for adding NCI to Enterprise Value, but in this case it’s the reverse. Theoretically, the value of any LTIs have already been priced into the parent’s share price and market capitalization using investors’ best assessment of the fair value of these assets. But to make the parent’s Enterprise Value comparable to those of other companies, we need to remove these assets. Because the LTIs are not consolidated, they are not part of the parent’s “operating” assets and do not generate EBITDA.

To make a multiple (such as Enterprise Value / EBITDA) comparable, the same collection of assets must be in the numerator as well as in the denominator. Suppose the parent has a 30% equity stake in another company (since they use the Equity Method, the investee company would not be consolidated). Without any adjustment to Enterprise Value for the LTI, the Enterprise Value would include the value of the 30% stake (since the stock market prices it into the stock price) but the EBITDA would have no contribution from those assets. So, we have a mismatch with 30% of the value of the investment in the parent’s Enterprise Value, but 0% of the investment’s EBITDA in the denominator. To correct this, we remove the value of the 30% stake from the Enterprise Value of the parent.

Importantly, this does not mean we are ignoring the value of the 30% stake. Rather, we would include the value of any LTIs (or other non-operating assets such as cash) in the equity value calculation.

Valuing Long-Term Investments for Enterprise Value

It is always best to use market values for all components of an Enterprise Value calculation. If you know the value of the long-term investment (LTI) is immaterial, it may be sufficient to use book value. However, where components of the LTIs are publicly-traded, use the share price times the number of shares owned by the parent. If the LTI is material but private, it might make sense to try to use a multiple to estimate the value of the investment.

Deriving Equity Value from Enterprise Value

The table below shows a simple example of deriving an Enterprise Value / EBITDA multiple, and then using this multiple to calculate a target company’s Equity Value. We calculate the Enterprise Value and the Enterprise Value / EBITDA multiple of the comparable company by starting with equity value (i.e. market capitalization) and then making the required adjustments to arrive at the Enterprise Value, which are the assets that generate the EBITDA. We then use the resulting multiple to estimate the Enterprise Value of the target company, and make the reverse adjustments to arrive at the implied equity value of the target company:

Enterprise Value Comparison

Where possible it is preferable to use market values for all the adjustments. Equity investors will attempt to place a market value on all the firm’s assets when pricing the stock, so when making adjustments, it is important to try to use the same basis.

The Effect of Dividends on Enterprise Value

If a company issues a dividend, its Enterprise Value does not change. If a $100 mm dividend is issued to shareholders, the company’s equity value is reduced by $100 mm which makes the company’s Enterprise Value go down by $100 mm. However, the company’s cash will decrease by $100 mm which makes the Enterprise Value increase by $100 mm. This is because Enterprise Value is equity value, plus debt, less cash. The net effect of these movements is that the Enterprise Value is not changed when a company issues a dividend. The other way to think about this question is that since cash is not an operating asset, paying a dividend does not impact the Enterprise Value (the value of the operating assets).

Paying a dividend is a financing decision. By paying a dividend, the company essentially becomes more levered, but the value of the underlying assets has not changed.