Equity and Enterprise 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

This is a “simplified” formula that you can usually get away with in interviews - may need to include a few more items

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.

To calculate the dilutive effect of options and warrants, you use the Treasury Stock Method.

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.

Question 17

Can you describe a few of the additional items that might be a part of Enterprise Value, beyond Cash, Debt, Preferred Stock, and Noncontrolling Interests, and explain whether you add or subtract each one?

Answer 17

Items That May Be Counted as Cash-Like Items and Subtracted:
• Net Operating Losses – Because you can use these to reduce future taxes; may or may not be true depending on the company and deal.
• Short-Term and Long-Term Investments – Because theoretically you can sell these off and get extra cash. May not be true if they’re illiquid.
• Equity Investments – Any investments in other companies where you own between 20% and 50%; this one is also partially for comparability purposes since revenue and profit from these investments shows up in the company’s Net Income, but not in EBIT, EBITDA, and Revenue (see the Accounting section).

Items That May Be Counted as Debt-Like Items and Added:
• Capital Leases – Like Debt, these have interest payments and may need to be repaid.
• (Some) Operating Leases – Sometimes you need to convert Operating Leases to Capital Leases and add them as well, if they meet the criteria for qualifying as Capital Leases (see the Accounting section).
• Unfunded Pension Obligations – These are usually paid with something other than the company’s normal cash flows, and they may be extremely large.
• Restructuring / Environmental Liabilities – Similar logic to Unfunded Pension Obligations.

Question 18

Should you use the Book Value or Market Value of each item when calculating Enterprise Value?

Answer 18

Technically, you should use market value for everything. In practice, however, you usually use market value only for the Equity Value portion because it’s difficult to determine market values for the rest of the items in the formula – so you take the numbers from the company’s Balance Sheet.

Question 19

What percentage dilution in Equity Value is “too high?”

Answer 19

There’s no strict “rule” here, but most bankers would say that anything over 10% is odd. If the basic Equity Value is $100 million and the diluted Equity Value is $115 million, you might want to check your calculations – it’s not necessarily wrong, but over 10% dilution is unusual for most companies. And something like 50% dilution would be highly unusual.

Question 20

How do you factor in Convertible Preferred Stock in the Enterprise Value calculation?

Answer 20

The same way you factor in normal Convertible Bonds: if it’s in-the-money, you assume that new shares get created, and if it’s not in the money, you count it as Debt.

Question 21

How do you factor in Restricted Stock Units (RSUs) and Performance Shares when calculating Diluted Equity Value?

Answer 21

RSUs should be added to the common share count, because they are just common shares. The only difference is that the employees who own them have to hold onto them for a number of years before selling them.

Performance Shares are similar to Convertible Bonds, but if they’re not in-the-money (the share price is below the performance share price target), you do not count them as Debt – you just ignore them altogether. If they are in-the-money, you assume that they are normal common shares and add them to the share count.

Question 22

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 22

The fully diluted share count is 105 and the Diluted Equity Value is $1,050.

Question 23

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 23

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

Question 24

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 24

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

Question 25

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 25

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 26

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 26

Enterprise Value = $222,000 – $10,000 + $30,000 + $15,000 = $257,000.