2.5) Calculating Equity Value and Enterprise Value Flashcards
- Is it accurate to subtract 100% of the Cash balance when moving from Equity Value to Enterprise Value?
No, but everyone does it anyway. A portion of any company’s Cash balance is an “Operating Asset” because the company needs a minimum amount of Cash to continue running its business. So, technically, you should subtract only the Excess Cash, i.e. MAX(0, Cash Balance – Minimum Cash). However, companies rarely disclose this number, and it varies widely between different industries, so everyone subtracts the entire Cash balance.
- Why do you NOT subtract Goodwill when moving from Equity Value to Enterprise Value? The company doesn’t need it to continue operating its business.
Goodwill reflects the premiums paid for previous acquisitions – if you subtracted it, you’d be saying, “Those previous acquisitions are not a part of this company’s core business anymore.” And that’s true only if the company has shut down or sold those companies, in which case it should have removed all Assets and Liabilities associated with them.
- Why do you subtract only part of a company’s Deferred Tax Assets (DTAs) when calculating Enterprise Value?
Deferred Tax Assets contain many different items, some of which are related to simple timing differences or tax credits for operational items. But you should subtract ONLY the Net Operating Losses (NOLs) in the DTA because those are considered Non-Operating Assets (and they have some potential value to acquirers in M&A deals); they’re less related to operations than the rest of the items in a DTA. You may also reduce the NOL in proportion to the Valuation Allowance / DTA, as the Valuation Allowance indicates that the company does not expect to realize the full benefits of the DTA.
- How do you factor in Working Capital when moving from Equity Value to Enterprise Value?
You don’t. Equity Value represents Net Assets to Common Shareholders, and Enterprise Value represents Net Operating Assets to All Investors. Each item in Working Capital counts in both Net Assets and Net Operating Assets, so you don’t adjust anything because both Eq Val and TEV include the full value of Working Capital. NOTE: By “Working Capital” here, we mean “Operating Working Capital,” i.e., the Working Capital number excluding Cash, Debt, etc.
- Why do you subtract Equity Investments, AKA Associate Companies, when moving from Equity Value to Enterprise Value?
First, they’re Non-Operating Assets since the Parent Company has only minority stakes in these companies and, therefore, cannot control them. Second, you subtract them for comparability purposes. Metrics like EBITDA, EBIT, and Revenue include 0% of these companies’ financial contributions, but Equity Value implicitly includes the value of the stake (e.g., 30% of the Associate Company’s Value if the Parent owns 30% of it). Therefore, you subtract the Equity Investments when moving from Equity Value to Enterprise Value to ensure that the numerator of TEV-based multiples – Enterprise Value – completely excludes Equity Investments, matching the metrics in the denominator that also exclude them.
- Why do you add Noncontrolling Interests (NCI) when moving from Equity Value to Enterprise Value?
First, these Noncontrolling Interests represent another investor group beyond the common shareholders: the minority shareholders of the Other Company in which the Parent Company owns a majority stake. The Parent Company effectively controls this Other Company now, so it counts these minority owners as an investor group. Second, you add NCI for comparability purposes. Since the financial statements are consolidated 100% when the Parent Company owns a majority stake in the Other Company, metrics like Revenue, EBIT, and EBITDA include 100% of the Other Company’s financials. Equity Value, however, includes only the value of the actual percentage the Parent owns. So, if a Parent Company owns 70% of the Other Company, the Parent Company’s Equity Value will include the value of that 70% stake. But its Revenue, EBIT, and EBITDA include 100% of the Other Company’s Revenue, EBIT, and EBITDA.
Therefore, you add the 30% the Parent Company does not own – the Noncontrolling Interest – when you move from Equity Value to Enterprise Value so that Enterprise Value reflects 100% of that Other Company’s value. Doing so ensures that metrics such as TEV / Revenue and TEV / EBITDA include 100% of the Other Company in both the numerator and the denominator.
- Should you add on-Balance Sheet Operating Leases in the Equity Value to Enterprise Value bridge?
Under U.S. GAAP, you could either add them or ignore them. If you add them, however, you have to pair TEV Including Operating Leases with EBITDAR; multiples such as TEV / EBIT and TEV / EBITDA are no longer valid because the denominators deduct the full Rental Expense. Under IFRS, you pretty much have to add the Operating Leases in the TEV bridge because metrics such as EBITDA already exclude the Interest and Depreciation elements of the Lease Expense. It’s questionable whether or not Operating Leases represent “another investor group,” so this adjustment is made mostly for comparability and consistency.
- At a high level, how do Pensions factor into the Enterprise Value calculation?
Only Defined-Benefit Pension plans factor in because Defined-Contribution Plans do not appear on the Balance Sheet. You should add the Unfunded or Underfunded portion, i.e., MAX(0, Pension Liabilities – Pension Assets), in the TEV bridge because the employees represent another investor group in this case. They agree to lower pay and benefits today in exchange for fixed payments once they retire, and the company must fund the pension and invest the funds appropriately. If contributions into the pension plan are tax-deductible, then you should also multiply the number by (1 – Tax Rate) in the bridge.
- What is the difference between Basic Equity Value and Diluted Equity Value? What do they mean?
Basic Equity Value is Common Shares Outstanding * Current Share Price, while Diluted Equity Value includes the impact of dilutive securities, such as options, warrants, RSUs, and convertible bonds, and is Diluted Shares Outstanding * Current Share Price. Companies create and issue these dilutive securities to incentivize employees to stay at the company (and to raise funds, in the case of convertible bonds). Basic vs. Diluted Equity Value does not “mean” anything in particular, but Diluted Equity Value is a more accurate measure of what the company’s Net Assets are worth to common shareholders.
- A company has 100 shares outstanding, and its current share price is $10.00. It also has 10 options outstanding at an exercise price of $5.00 each. What is its Diluted Equity Value?
Its Basic Equity Value is 100 * $10.00 = $1,000. To calculate the diluted shares, note that the options are all “in the money” – their exercise price is less than the current share price. When these options are exercised, 10 new shares are created, so the share count increases to 110. The investors paid the company $5.00 to exercise each option, so the company gets $50 in cash. It uses that cash to buy back 5 of the new shares, so the diluted share count is 105, and the Diluted Equity Value is $1,050.
- A company has 1 million shares outstanding, and its current share price is $100.00. It also has $10 million of convertible bonds, with a par value of $1,000 and a conversion price of $50.00. What are its diluted shares outstanding and Diluted Equity Value?
First, note that these convertible bonds are convertible into shares because the company’s share price is above the conversion price. So, you do count them as additional shares. These convertible bonds will create $10 million / $50.00 = 200,000 new shares. You don’t use the Treasury Stock Method with convertibles because the investors don’t pay the company to convert the bonds into shares; they paid for the bonds upon the first issuance. So, the diluted shares are 1.2 million, and the Diluted Equity Value is $120 million.
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12. A company has 10,000 shares outstanding and a current share price of $20.00. It has 100 options outstanding at an exercise price of $10.00. It also has 50 Restricted Stock Units (RSUs) outstanding. Finally, it also has 100 convertible bonds outstanding at a conversion price of $10.00 and par value of $100. What is its Diluted Equity Value?
Since the options are in-the-money, you assume that they get exercised, so 100 new shares are created. The company receives 100 * $10.00, or $1,000, in proceeds. Its share price is $20.00, so it can repurchase 50 shares with these proceeds. There are now 50 net additional shares outstanding. You add the 50 RSUs as if they were common shares, so now there’s a total of 100 additional shares outstanding. The company’s share price of $20.00 exceeds the conversion price of $10.00, so the convertible bonds can convert into shares. Divide the par value by the conversion price to determine the shares per bond: $100 / $10.00 = 10 new shares per bond There are 100 individual convertible bonds, so you get 1,000 new shares. These changes create 1,100 additional shares outstanding, so the diluted share count is now 11,100, and the Diluted Equity Value is 11,100 * $20.00, or $222,000.
- This same company also has Cash of $10,000, Debt of $30,000, and Noncontrolling Interests of $15,000. What is its Enterprise Value?
You subtract the Cash, add the Debt, and then add Noncontrolling Interests: Enterprise Value = $222,000 – $10,000 + $30,000 + $15,000 = $257,000.
- A company issued a convertible bond in a “capped call” transaction where it also purchased call options on its own stock at an exercise price equal to the conversion price and sold warrants on its stock at a higher exercise price.
How would you estimate the dilution in this case?
In capped call transactions, the call options typically offset all the initial dilution from the convertible bond. New shares get created, but then the company exercises its call options to repurchase them. Then, you apply the Treasury Stock Method to the warrants sold at the higher exercise price, such as $100 if the conversion price is $60 or $70. So, if the company’s current share price is $40, there will be no dilution until it reaches $100 – at which point you will use the TSM to calculate the dilution from the warrants. Note: This logic may not hold up if the company purchases a different number of call options, such as 1,000 when the potentially dilutive shares from the convertible bond are 1,100 or 1,200. So, we are making some simplifying assumptions here, but this is the basic idea.
