Enterprise Value and Equity Value

Question 1

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

Answer 1

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 2

How do you use Equity Value and Enterprise Value differently?

Answer 2

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 3

What’s the formula for Enterprise Value?

Answer 3

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

Question 4

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

Answer 4

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 5

How do you calculate diluted shares and Diluted Equity Value?

Answer 5

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.

Question 6

Why do we bother calculating share dilution? Does it even make much of a difference?

Answer 6

We do it for the same reason we calculate Enterprise Value: to more accurately determine the cost of acquiring a company.

Normally in an acquisition scenario, in-the-money securities (ones that will cause additional shares to be created) are 1) Cashed out and paid by the buyer (raising the purchase price), or 2) Are converted into equivalent securities for the buyer (also raising the effective price for the buyer).

Dilution doesn’t always make a big difference, but it can be as high as 5-10% (or more) so you definitely want to capture that.

Question 7

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

Answer 7

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 8

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

Answer 8

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 it for others, EV would no longer mean the same thing and valuation multiples would be off.

Question 9

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

Answer 9

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 10

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

Answer 10

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

Question 11

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

Answer 11

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 12

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

Answer 12

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 13

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

Answer 13

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 14

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

Answer 14

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

Question 15

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 15

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 16

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 16

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… starting to notice a pattern here?

Question 17

Let’s say a company has 100 shares outstanding, at a share price of $10.00 each. It also has 10 options outstanding at an exercise price of $5.00 each – what is its Diluted Equity Value?

Answer 17

Its basic equity value is $1,000 (100 * $10 = $1,000). To calculate the dilutive effect of the options, first you 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 get created – so the share count is now 110 rather than 100.

However, that doesn’t tell the whole story. In order to exercise the options, we had to “pay” the company $5 for each option (the exercise price).

As a result, it now has $50 in additional cash, which it uses to buy back 5 of the new shares we created.
So the fully diluted share count is 105 and the Diluted Equity Value is $1,050.

Question 18

Let’s say a company has 100 shares outstanding, at a share price of $10 each. It also has 10 options outstanding at an exercise price of $15 each – what is its Diluted Equity Value?

Answer 18

$1,000. In this case the options’ exercise price is above the current share price, so they have no dilutive effect.

Question 19

A company has 1 million shares outstanding at a value of $100 per share. It also has $10 million of convertible bonds, with par value of $1,000 and a conversion price of $50. How do I calculate diluted shares outstanding?

Answer 19

This gets confusing because of the different units involved. First, note that these convertible bonds are in-the-money because the company’s share price is $100, but the conversion price is $50. So we count them as additional shares rather than debt.

Next, we need to divide the value of the convertible bonds – $10 million – by the par value – $1,000 – to figure out how many individual bonds there are:
$10 million / $1,000 = 10,000 convertible bonds.

Next, we need to figure out how many shares this number represents. The number of shares per bond is the par value divided by the conversion price:
$1,000 / $50 = 20 shares per bond.

So we have 200,000 new shares (20 * 10,000) created by the convertibles, giving us 1.2 million diluted shares outstanding.

We do not use the Treasury Stock Method with convertibles because we do not pay the company anything to “convert” the convertibles – it just becomes an option automatically once the share price exceeds the conversion price.

Question 20

Let’s say that a company has 10,000 shares outstanding and a current share price of $20.00. It also 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?

Answer 20

First, let’s tackle the options outstanding: since they are in-the-money (exercise price is lower than the share price), we assume that they get exercised and that 100 new shares get 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. Overall, there are 50 additional shares outstanding now (100 new shares – 50 repurchased).

The 50 RSUs get added as if they were common shares, so now there’s a total of 100 additional shares outstanding.

For the convertible bonds, the conversion price of $10.00 is below the company’s current share price of $20.00, so conversion is allowed.

We divide the par value by the conversion price to see how many new shares per bond get created:
$100 / $10.00 = 10 new shares per bond
Since there are 100 convertible bonds outstanding, we therefore get 1,000 new shares (100 convertible bonds * 10 new shares per bond).

In total, there are 1,100 additional shares outstanding. The diluted share count is therefore 11,100.

The Diluted Equity Value is 11,100 * $20.00, or $222,000.

Question 21

This same company also has Cash of $10,000, Debt of $30,000, and Noncontrolling Interests of $15,000. What is its Enterprise Value?

Answer 21

You subtract the Cash, add the Debt, and then add Noncontrolling Interests: Enterprise Value = $222,000 – $10,000 + $30,000 + $15,000 = $257,000.