2.2) The Concepts of Equity Value and Enterprise Value Flashcards
- What do Equity Value and Enterprise Value MEAN? Don’t explain how you calculate them – tell me what they mean!
Equity Value represents the value of EVERYTHING a company has (its Net Assets) but only to EQUITY INVESTORS (i.e., common shareholders). Enterprise Value represents the value of the company’s CORE BUSINESS OPERATIONS (its Net Operating Assets) but to ALL INVESTORS (Equity, Debt, Preferred, and possibly others).
- Why do you use both Equity Value and Enterprise Value? Isn’t Enterprise Value more accurate?
Neither one is “better” or “more accurate” – they represent different concepts, and they’re important to different types of investors. Enterprise Value and TEV-based multiples have some advantages because they are not affected by changes in the company’s capital structure as much as Equity Value and Eq Val-based multiples are affected. However, in valuation, one methodology might produce Implied Enterprise Value, while another might produce Implied Equity Value, so you will need to move between them to analyze a company. Finally, you use both of them because actions taken by one investor group affect all the other groups. If a company raises Debt, that also affects the risk and potential returns for common shareholders.
- Why do you pair Net Assets with Common Shareholders in Equity Value, but Net Operating Assets with All Investors in Enterprise Value? Isn’t that an arbitrary pairing?
No. The logic is that Common Shareholders’ Equity can be generated internally (via Net Income) or raised externally (Stock Issuances), so the company can use it for both Operating and Non-Operating Assets. But if the company raises funds via outside investors (Debt, Preferred Stock, etc.), then most likely it will use those funds to pay for Operating Assets, rather than spending the money on random Non-Operating Assets (such as a whiskey side business for a software company). This rule does not always hold up in real life, but this is the basic rationale.
- What’s the difference between Current Enterprise Value and Implied Enterprise Value?
Current Enterprise Value is what “the market as a whole” thinks the company’s core business operations are worth to all investors; Implied Enterprise Value is what you think the core-business operations are worth based on your views and analysis. You calculate Current Enterprise Value for public companies by starting with Current Equity Value, subtracting Non-Operating Assets, and adding Liability and Equity line items that represent other investor groups (i.e., ones beyond the common shareholders). But you calculate Implied Enterprise Value based on valuation methodologies such as the Discounted Cash Flow (DCF) analysis, comparable public companies, and precedent transactions.
- Why might a company’s Current Enterprise Value be different from its Implied Enterprise Value?
Remember that Company Value = Cash Flow / (Discount Rate – Cash Flow Growth Rate), where Cash Flow Growth Rate < Discount Rate. Everyone agrees on a company’s current Cash Flow, but you might disagree with the market on the Discount Rate or Cash Flow Growth Rate. In most cases, your view of a company’s value will be different than the market’s view because you believe its cash flow will grow at a faster or slower rate.
- Why do you subtract Cash, add Debt, and add Preferred Stock when moving from Equity Value to Enterprise Value in the “bridge”?
You subtract Non-Operating Assets because Enterprise Value reflects only Net Operating Assets. Cash and Investments are examples of Non-Operating Assets, but Equity Investments (Associate Companies), Assets Held for Sale, and Assets Associated with Discontinued Operations also count. You add Liability & Equity line items that represent other investor groups beyond the common shareholders because Enterprise Value represents All Investors. Debt and Preferred Stock are the most common examples, but Underfunded Pensions, Capital Leases, and Noncontrolling Interests also qualify.
- You’re about to buy a house using a $600K mortgage and a $200K down payment. What are the real-world analogies for Equity Value and Enterprise Value in this case?
The “Enterprise Value” here is the $800K total price of the house, and the “Equity Value” is the $200K down payment you’re making.
- Could a company’s Equity Value ever be negative?
Trick question. A company’s Current Equity Value cannot be negative because it is based on Shares Outstanding * Current Share Price, and neither of those can be negative. It also can’t be negative for private companies. However, its Implied Equity Value could be negative because you use your views and assumptions to calculate that. If the company’s Implied Enterprise Value is $0, for example, and it has more Debt than Cash, then its Implied Equity Value will be negative. Note, however, that you typically say its Equity Value is $0 in cases like this.
- Could a company’s Enterprise Value ever be negative?
Yes. Both Current and Implied Enterprise Value could be negative – for example, a company might have Cash that exceeds its Current Equity Value and no Debt. And your Implied Enterprise Value might be the same as, or close to, its Current Enterprise Value.
Once again, you often say the company’s Enterprise Value is simply $0 in cases like this.
- Why do financing events such as paying Dividends or issuing Debt not affect Current Enterprise Value?
Current Enterprise Value changes only if Net Operating Assets change. Paying Dividends reduces the company’s Cash and Common Shareholders’ Equity, and issuing Debt increases the company’s Cash and Debt. None of these is an Operating Asset or Liability, so Current Enterprise Value cannot possibly change.
- You estimate a company’s Implied Value with Company Value = Cash Flow / (Discount Rate – Cash Flow Growth Rate), where Cash Flow Growth Rate < Discount Rate. Will this give you the company’s Implied Equity Value or Implied Enterprise Value?
It depends on the type of Cash Flow and the Discount Rate you are using. If you’re using Cash Flow Available to All Investors (i.e., Unlevered FCF or Free Cash Flow to Firm) and WACC for the Discount Rate, then this formula will produce the Implied Enterprise Value. If you’re using Cash Flow Available ONLY to Equity Investors (i.e., Levered FCF or Free Cash Flow to Equity) and Cost of Equity for the Discount Rate, then this formula will produce the Implied Equity Value.
- If financing events do not affect Current Enterprise Value, what DOES affect it?
Only changes to the company’s Net Operating Assets (i.e., changes to its “core business”) affect Enterprise Value. For example, if the company purchases PP&E using Cash, or it raises Debt to purchase PP&E or Inventory, both of those will increase Current Enterprise Value.
- Is it possible for a single change to affect both Current Equity Value and Current Enterprise Value?
Yes. For this to happen, Net Operating Assets must change, and Common Shareholders’ Equity must also change.
So, for example, if the company issues $100 of Common Stock to fund the purchase of $100 in PP&E, both Eq Val and TEV will increase by $100.
- Why does Enterprise Value NOT necessarily represent the “true cost” to acquire a company?
First, because the treatment of the seller’s existing Debt and Cash differs based on the terms of the deal. The buyer may not necessarily “repay” the seller’s Debt – it could instead refinance it and replace it with new Debt – and it may not “get” all the seller’s Cash. Also, the buyer has to pay additional fees for the M&A advisory, accounting, and legal services, and the financing to acquire another company, and those are not reflected in its Enterprise Value.
- In theory, if Companies A and B are the same in all respects, but Company A is financed with 100% Equity, and Company B is financed with 50% Equity and 50% Debt, then their Enterprise Values will be the same. Why is this NOT true in reality?
Because a company’s capital structure, whether current, optimal, or targeted, affects the Discount Rate used to calculate the Implied Enterprise Value (and the Discount Rate “the market as a whole” uses for the company’s Current Enterprise Value). Not only do the percentages of Equity, Debt, and Preferred Stock affect WACC, but the Cost of each one also changes as the company’s capital structure changes. For example, going from no Debt to a small amount of Debt may initially reduce WACC because Debt is cheaper than Equity. But past a certain point, additional Debt will increase WACC because the risk to all investors starts increasing at that stage. Enterprise Value is LESS affected by capital structure changes than Equity Value, but there will still be some effect.
