Equity & Enterprise Value (Advanced) from BIWS 400 Flashcards
Are there any problems with the Enterprise Value formula you just gave me?
Yes – it’s too simple. There are lots of other things you need to add into the formula with real companies:
- Net Operating Losses – Should be valued and arguably added in, similar to cash.
- Long-Term Investments – These should be counted, similar to cash.
- Equity Investments – Any investments in other companies should also be added in, similar to cash (though they might be discounted).
- Capital Leases – Like debt, these have interest payments – so they should be added in like debt.
- (Some) Operating Leases – Sometimes you need to convert operating leases to capital leases and add them as well.
- Unfunded Pension Obligations – Sometimes these are counted as debt as well.
So a more “correct” formula would be Enterprise Value = Equity Value – Cash + Debt + Preferred Stock + Noncontrolling Interest – NOLs – LT and Equity Investments + Capital Leases + Unfunded Pension Obligations…
In interviews, usually you can get away with saying “Enterprise Value = Equity Value Cash + Debt + Preferred Stock + Noncontrolling Interest”
I mention this here because in more advanced interviews you might get questions on this topic.
Should you use the book value or market value of each item when calculating Enterprise Value?
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 almost impossible to establish market values for the rest of the items in the formula – so you just take the numbers from the company’s Balance Sheet.
What percentage dilution in Equity Value is “too high?”
There’s no strict “rule” here but most bankers would say that anything over 10% is odd. If your 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.
Can 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 can be negative because you use your assumptions to calculate that. So, if the company’s Implied Enterprise Value is $0, for example, and it has more Debt than Cash, its Implied Equity Value will be negative.
Can a company’s Enterprise Value ever be negative?
Yes. Both Current and Implied Enterprise Value could easily be negative – for example, a company might have more Cash than its Market Cap (Current Equity Value) and no Debt. And perhaps your Implied Enterprise Value is the same as, or very close to, its Current Enterprise Value.
Why do financing-related events such as issuing Dividends or raising Debt not affect Enterprise Value?
Because Enterprise Value reflects the value of a company’s core business operations to ALL investors in the company. That definition means that if something does not affect the company’s core business, it won’t affect Enterprise Value. Issuing Dividends, issuing Stock, repurchasing Stock, issuing/repaying Debt, etc. do not impact a company’s core business, so they do not affect Enterprise Value. Note that in reality, there will still be a small impact on Enterprise Value; this is just the theory.
Let’s say you determine a company’s Implied Value with the cash flow formula: Company Value = Cash Flow / (Discount Rate – Cash Flow Growth Rate). Will this give you a 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 that’s available to ALL investors (i.e., Unlevered FCF or Free Cash Flow to Firm), and WACC for the Discount Rate, this formula will produce the Implied Enterprise Value. If you’re using Cash Flow that’s available ONLY to equity investors (i.e., Levered FCF or Free Cash Flow to Equity), and Cost of Equity for the Discount Rate, this formula will produce the Implied Equity Value.
If financing-related events do not affect Enterprise Value, what DOES affect it?
Only changes to a company’s core business will affect Enterprise Value. For example, the company wins a major new customer contract, or it announces higher-than-expected sales, or it closes a factory, or it announces positive results from an expansion strategy into Africa. But remember that this is all in theory. In reality, financing changes will still make a small impact on Enterprise Value.
If a company wins a major contract with a new customer, will ONLY Enterprise Value change? Or will Equity Value also change?
Equity Value will change as well. The whole point of Equity Value is that it is affected by BOTH operational and financial changes, whereas Enterprise Value is affected by ONLY operational changes (in theory).
Why does Enterprise Value NOT necessarily represent the “true cost” to acquire a company?
First, because the buyer may not necessarily have to repay the seller’s Debt – in 99% of cases, they do, or they have to “refinance it” by replacing it with new Debt, but there are exceptions.
Second, the buyer may not “get” the seller’s entire Cash balance. The seller needs a certain minimum amount of Cash to continue operating, and so the seller’s Cash may not reduce the effective purchase price 1-for-1.
Finally, the buyer has to pay additional fees for M&A advisory, accounting, legal services, and financing to acquire another company, and none of those is reflected in Enterprise Value.
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 additional shares outstanding (100 new shares – 50 repurchased).
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 convertible bonds outstanding, so you get 1,000 new shares (100 convertible bonds * 10 new shares per bond). All of 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.
