BIWS Module 1 - Equity and Enterprise Value

Question 1

What is equity value also known as?

Answer 1

Market Cap

Question 2

How do you calculate equity value/market cap?

Answer 2

Number of Shares x Share Price

Question 3

What does enterprise value represent?

Answer 3

The actual cost to acquire a company

Question 4

What is the enterprise value equation?

Answer 4

Equity Value + Debt, Debt-Like Items
and Other Obligations – Cash, Cash-Like Items, and Anything That Saves Us Money

Question 5

What do we add and subtract when calculating EV? (General)

Answer 5

Add anything that we’re going to have to set aside funds to pay off in the future, and subtract anything that can save us money in the future

Question 6

What makes a security dilutive? Provide a definition and an example.

Answer 6

A security is “dilutive” if it could potentially create more shares. The best example is a call option, which gives someone (usually an employee) the ability to pay the company money and get a newly created share in return

Question 7

What is in-the-money vs out-of-the-money?

Answer 7

In the money = Exercise Price < Share Price

Out-of-the-money = Exercise Price > Share Price

Question 8

Why would an employee wait to exercise an in-the-money option?

Answer 8

Expectations of future value. If they think that the share price will rise next week, they’ll most likely hold onto their options. Also, employees may be restricted from exercising their options depending on how long they’ve worked at the company in question

Question 9

How do you calculate the impact of diluted shares?

Answer 9

Treasury Stock Method

Question 10

What is the Treasury Stock Method?

Answer 10

Assume that the new
shares get created when options are exercised, and that
the company then buys back some of those new shares
with the funds it receives

Question 11

Treasury Stock Method Example: Let’s say that the company’s share price is $10.00 and that 100 options were issued at $5.00 exercise prices.

Answer 11

Since its share price is $10.00, it can therefore buy back 50 shares with the proceeds. So as a result, there are 50 additional shares outstanding and the diluted share count goes up by 50

Question 12

How do you treat warrants in enterprise value calculation?

Answer 12

Treasury Stock Method

Question 13

How do you treat convertible bonds in enterprise value calculation?

Answer 13

Treatment is “either or” – they count as debt, or count 100% as additional shares, with no Treasury Stock Method involved

Question 14

How do you treat convertible preferred stock in enterprise value calculation?

Answer 14

Treatment is “either or” – they count as debt, or count 100% as additional shares, with no Treasury Stock Method involved

Question 15

How do you treat restricted stock units in enterprise value calculation?

Answer 15

These are a straight addition – there are no exercise prices or conversion prices to worry about

Question 16

When do you subtract an item from equity value to find enterprise value?

Answer 16

When it saves you money or gives you extra cash, either immediately or in the long-term

Question 17

When do you add an item from equity value to find enterprise value?

Answer 17

1) When it represents something
that must be paid immediately upon acquiring the company (e.g. Debt), or
2) When it’s something that must be repaid in the future, but wouldn’t
come from the company’s normal cash flows (e.g. Unfunded Pension Obligations); or
3) When you’re adding it back for comparability purposes (e.g. Noncontrolling Interests).”

Question 18

Would you add or subtract cash?

Answer 18

Subtract (only excess cash - amount over min needed for opps)

Question 19

Would you add or subtract ST, LT, and Equity Investments?

Answer 19

Subtract - could be sold in future and get extra cash (depends on investment liquidity)

Question 20

Would you add or subtract Net Operating Losses?

Answer 20

Subtract - These could potentially save you cash as future tax deductions, so sometimes they are factored in (standards vary widely)

Question 21

Would you add or subtract Debt?

Answer 21

Add - acquirer normally must repay debt upon completing the acquisition

Question 22

Would you add or subtract Preferred Stock?

Answer 22

Add - similar to Debt because of the required dividends, which act as interest expense; also, normally it must also be repaid upon acquisition.

Question 23

Would you add or subtract Unfunded Pension Obligations?

Answer 23

Add - if they do not have the cash flow from normal business operations to pay for it

Question 24

Would you add or subtract Capital Leases?

Answer 24

Add - if they do not have the cash flow from normal business operations to pay for it

Question 25

Would you add or subtract Restructuring/Environmental Liabilities?

Answer 25

Add - if they do not have the cash flow from normal business operations to pay for it

Question 26

Why do you add back Noncontrolling Interests for comparability purposes?

Answer 26

"You add these because when you own over 50% of another company, you consolidate 100% of its financial statements with your own. But Equity Value only reflects the value of the percentage that you own, not 100%. So you need to reflect 100% of that other company in Enterprise Value – if you did not add Noncontrolling Interests, you would only be reflecting 60%, or 70%, or however much you own. Let’s say that your revenue is $100, and you own 70% of another company that has $50 in revenue. On your statements, you show $150 in revenue because you consolidate 100% of the statements (see the Accounting section of the guide). But Equity Value, by itself, only reflects the 70% of the other company that you own. An Enterprise Value / Revenue multiple would be wrong because we would have 100% of the other company’s revenue, but only 70% of its value. As a result, we need to add the Noncontrolling Interests line item that reflects the 30% we do not own – that way, we’re including 100% of the other company’s value in Enterprise Value"

Question 27

Is equity value or enterprise value more meaningful for commercial banking and insurance firms? Why

Answer 27

Only equity value is meaningful Why? Banks and insurers earn revenue from their liabilities (e.g., deposits, premiums, debt instruments), making it difficult to separate operating and financing activities. Debt is more of an operational necessity rather than an optional financing choice, making EV an unreliable measur

Question 28

How do you decide to use enterprise or equity value when calculating valuation multiples? Why?

Answer 28

1) If denominator includes interest income and expense use equity value since this is income after debt holders are paid and therefore debt holders are no longer entitled to anything and it belongs to equity investors therefore we use equity value 2) If denominator doesn't include interest income and expense, this cash flow is available to both equity and debt investors and therefore it corresponds to enterprise value

Question 29

In multiples calculation, if you have revenue in the denominator, do you use Enterprise Value or Equity Value in the numerator?

Answer 29

Enterprise Value

Question 30

In multiples calculation, if you have EBIT or Operating Income in the denominator, do you use Enterprise Value or Equity Value in the numerator?

Answer 30

Enterprise Value

Question 31

In multiples calculation, if you have EBITDA in the denominator, do you use Enterprise Value or Equity Value in the numerator?

Answer 31

Enterprise Value

Question 32

In multiples calculation, if you have Net Income (EPS) in the denominator, do you use Enterprise Value or Equity Value in the numerator?

Answer 32

Equity Value (Per Share Price)

Question 33

In multiples calculation, if you have Unlevered Free Cash Flow in the denominator, do you use Enterprise Value or Equity Value in the numerator?

Answer 33

Enterprise Value

Question 34

In multiples calculation, if you have Levered Free Cash Flow in the denominator, do you use Enterprise Value or Equity Value in the numerator?

Answer 34

Equity Value

Question 35

What is a simple trick to determine if Equity Value or Enterprise Value should be used as numerator in multiples calculation?

Answer 35

"“Does this include interest income and expense, i.e. do we subtract interest expense and add interest income to get to this metric?” If it does, use Equity Value; if it does not, use Enterprise Value."

Question 36

Why do we look at both Enterprise Value and Equity Value?

Answer 36

"Enterprise Value represents the value of the company that is attributable to all investors; Equity Value only represents the portion available to shareholders (equity investors). You look at both because Equity Value is the number the public-at-large sees (“the sticker price”), while Enterprise Value represents its true value, i.e. what it would really cost to acquire."

Question 37

How do you use Equity Value and Enterprise Value differently?

Answer 37

"Equity Value gives you a general idea of how much a company is worth; Enterprise Value tells you, more specifically, how much it would cost to acquire. Also, you use them differently depending on the valuation multiple you’re calculating. If the denominator of the multiple includes interest income and expense (e.g. Net Income), you use Equity Value; otherwise, if it does not (e.g. EBITDA), you use Enterprise Value."

Question 38

What’s the formula for Enterprise Value?

Answer 38

Enterprise Value = Equity Value + Debt + Preferred Stock + Noncontrolling Interests – Cash

Question 39

Why do you need to add Noncontrolling Interests to Enterprise Value?

Answer 39

Whenever a company owns over 50% of another company, it is required to report 100% of the financial performance of the other company as part of its own performance. So even though it doesn’t own 100%, it reports 100% of the majority-owned subsidiary’s financial performance. You must add the Noncontrolling Interest to get to Enterprise Value so that your numerator and denominator both reflect 100% of the majority-owned subsidiary. If you did not do that, the numerator would reflect less than 100% of the company, but the denominator would reflect 100%.

Question 40

How do you calculate diluted shares and Diluted Equity Value?

Answer 40

Take the basic share count and add in the dilutive effect of stock options and any other dilutive securities, such as warrants, convertible debt, and convertible preferred stock. To calculate the dilutive effect of options and warrants, you use the Treasury Stock Method (see the Calculations questions below).

Question 41

Why do you subtract Cash in the formula for Enterprise Value? Is that always accurate?

Answer 41

In an acquisition, the buyer would “get” the cash of the seller, so it effectively pays less for the company based on how large its cash balance is. Remember, Enterprise Value tells us how much you’d effectively have to “pay” to acquire another company. It’s not always accurate because technically you should subtract only excess cash – the amount of cash a company has above the minimum cash it requires to operate. But in practice, the minimum cash required by a company is difficult to determine; also, you want the Enterprise Value calculation to be relatively standardized among different companies, so you normally just subtract the entire cash balance.

Question 42

Is it always accurate to add Debt to Equity Value when calculating Enterprise Value?

Answer 42

In most cases, yes, because the terms of a Debt issuance usually state that Debt must be repaid in an acquisition. And a buyer usually pays off a seller’s Debt, so it is accurate to say that Debt “adds” to the purchase price. Adding Debt is also partially a matter of standardizing the Enterprise Value calculation among different companies: if you added it for some and didn’t add xit for others, EV would no longer mean the same thing and valuation multiples would be off.

Question 43

Could a company have a negative Enterprise Value? What does that mean?

Answer 43

Yes. It means that the company has an extremely large cash balance, or an extremely low market capitalization (or both). You often see it with companies on the brink of bankruptcy, and sometimes also with companies that have enormous cash balances.

Question 44

Could a company have a negative Equity Value? What would that mean?

Answer 44

No. This is not possible because you cannot have a negative share count and you cannot have a negative share price

Question 45

Why do we add Preferred Stock to get to Enterprise Value?

Answer 45

Preferred Stock pays out a fixed dividend, and Preferred Shareholders also have a higher claim to a company’s assets than equity investors do. As a result, it is more similar to Debt than common stock. Also, just like Debt, typically Preferred Stock must be repaid in an acquisition scenario.

Question 46

How do you factor in Convertible Bonds into the Enterprise Value calculation?

Answer 46

If the convertible bonds are in-the-money, meaning that the conversion price of the bonds is below the current share price, then you count them as additional dilution to the Equity Value (no Treasury Stock Method required – just add all the shares that would be created as a result of the bonds). If the Convertible Bonds are out-of-the-money, then you count the face value of the convertibles as part of the company’s Debt.

Question 47

What’s the difference between Equity Value and Shareholders’ Equity?

Answer 47

Equity Value is the market value and Shareholders’ Equity is the book value. Equity Value could never be negative because shares outstanding and share prices can never be negative, whereas Shareholders’ Equity could be positive, negative, or 0. For healthy companies, Equity Value usually far exceeds Shareholders’ Equity because the market value of a company’s stock is worth far more than its paper value. In some industries (e.g. commercial banks and insurance firms), Equity Value and Shareholders’ Equity tend to be very close.

Question 48

Should you use Enterprise Value or Equity Value with Net Income when calculating valuation multiples?

Answer 48

Since Net Income includes the impact of interest income and interest expense, you always use Equity Value.

Question 49

Why do you use Enterprise Value for Unlevered Free Cash Flow multiples, but Equity Value for Levered Free Cash Flow multiples? Don’t they both just measure cash flow?

Answer 49

They both measure cash flow, but Unlevered Free Cash Flow (Free Cash Flow to Firm) excludes interest income and interest expense (and mandatory debt repayments), whereas Levered Free Cash Flow includes interest income and interest expense (and mandatory debt repayments), meaning that only Equity Investors are entitled to that cash flow (see the funnel diagram above). Therefore, you use Equity Value for Levered Free Cash Flow and Enterprise Value for Unlevered Free Cash Flow.

Question 50

Let’s say we create a brand-new operating metric for a company that approximates its cash flow. Should we use Enterprise Value or Equity Value in the numerator when creating a valuation multiple based on this metric?

Answer 50

It depends on whether or not this new metric includes the impact of interest income and interest expense. If it does, you use Equity Value. If it does not, you use Enterprise Value

Question 51

What are restricted stock units?

Answer 51

A Restricted Stock Unit (RSU) is a type of employee compensation where an employer grants company shares that vest over time or based on performance. Employees don’t own the shares until they meet the vesting conditions, at which point the RSUs are taxed as ordinary income based on their market value. Unlike stock options, RSUs require no upfront purchase, making them a valuable incentive for employee retention and alignment with company performance.