Equity Value & 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 b/c Equity Value is the number the public-at-large sees (“the sticker price”) while Enterprise Value represents its true value (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.
• 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

Simple Formula:
• Enterprise Value = Equity Value + Debt + Preferred Stock + Non-controlling Interests - Cash

Advanced Formula:
• Enterprise Value = Equity Value + Debt + Preferred Stock + Non-controlling Interests + Capital Leases + Unfunded Pension Obligations and Other Liabilities - Cash - NOLs - Investments - Equity Investments

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. Even if 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.

Question 5

How do you calculated diluted shares and Diluted Equity Value?

Answer 5

• You 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 that 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 this effect.

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 b/c technically you should subtract only excess cash (the amount of cash a company has above the minimum cash required to operate)
• 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 always accurate to add Debt to Equity Value when calculating Enterprise Value?

Answer 8

• In most cases‚ yes‚ b/c 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 w/ 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 b/c you cannot have a negative share count or 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 Shareholder’s Equity?

Answer 13

• Equity Value is the market value and Shareholder’s Equity is the book value.
• Equity Value could never be negative b/c shares outstanding and share prices can never be negative‚ whereas Shareholder’s Equity can be positive‚ negative or zero.
• For healthy companies‚ Equity Value usually far exceeds Shareholder’s Equity b/c the market value of a company’s stock is worth far more than its paper value. In some industries (e.g. financial institutions)‚ Equity Value and Shareholder’s 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 FCF (FCF to firm) excludes interest income and interest expense (and mandatory debt repayments)‚ whereas Levered FCF includes interest income and interest expense (and mandatory debt repayments)‚ meaning that only Equity Investors are entitled to that cash flow.
• Therefore‚ you use Equity Value for Levered FCF and Enterprise Value for Unlevered FCF.

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 doesn’t‚ 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 (NOLs): b/c you can use these to reduce future taxes; may or may not be true depending on company and deal
• Short-Term and Long-Term Investments: b/c 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 20-50%; this one is also partially for comparability purposes since revenue and profit from these investments show up in the company’s Net Income‚ but not in EBIT‚ EBITDA‚ and Revenue

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 criteria for qualifying as Capital Leases
• Unfunded Pension Obligations: These are usually paid w/ 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

Wait a second‚ why might you add back Unfunded Pension Obligations but not something like Accounts Payable? Don’t they both need to be repaid?

Answer 18

• The distinctions are magnitude and source of funds. 99% of the time‚ A/P is paid back via the company’s cash flow from it’s normal business operations and it tends to be very small.
• Items like Unfunded Pension Obligations‚ by contrast‚ usually require additional funding (e.g. the company raises Debt) to be repaid. These types of liabilities also tend to be much bigger than Working Capital / Operational Asset and Liability items.

Question 19

Are there are any exceptions to the rules about subtracting Equity Interests and adding Noncontrolling Interests when calculating Enterprise Value?

Answer 19

• You pretty much always add Noncontrolling Interests b/c the financial statements are always consolidated when you own over 50% of another company.
• But with Equity Interests‚ you ONLY subtract them if the metric you’re looking at does NOT include Net Income from Equity Interests (which only appears toward the bottom of the I/S)
• For example: Revenue‚ EBIT‚ and EBITDA all exclude revenue and profit from Equity Interests‚ so you subtract Equity Interests.
• But with Levered FCF (FCF to Equity)‚ typically you’re starting w/ Net Income Attributable to Parent Company‚ which already includes Net Income from Equity Interests.
• Normally you subtract that out in the CFO section of the SCF so you would still subtract Equity Interests if you calculate FCF by going through all the items in that section.
• But if you have not subtracted out Net Income from Equity Interests (if you’ve used some other formula to calculate FCF)‚ you should NOT subtract it in the Enterprise Value calculation - you WANT to show its impact in that case.
• This is a very subtle point‚ most bankers would probably not understand the explanation above.

Question 20

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

Answer 20

Technically you should use Market Value for everything. In practice‚ however‚ you usually use market value only for the Equity Value portion b/c 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 21

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

Answer 21

• There’s no strict rule here‚ but most bankers would say that anything over 10% is odd.
• If the basic Equity Value is $100M and the diluted Equity Value is $115M‚ 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 22

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

Answer 22

The same way you would 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 23

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

Answer 23

• RSUs should be added to the common share count‚ b/c 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 ignore them altogether. If they are in-the-money‚ you assume that they are normal common share and add them to the share count.

Question 24

What’s the distinction between Options Exercisable vs. Options Outstanding? Which one(s) should you use when calculating share dilution?

Answer 24

• Options Exercisable vs. Options Outstanding: normally companies put in place restrictions on when employees can actually exercise options - so even there are 1M options outstanding right now‚ only 500K may actually be exercisable EVEN IF they’re all in-the-money.
• There’s no correct answer for which one to use here. Some people argue that you should use Options Outstanding b/c typically‚ all non-exercisable Options become exercisable in an acquisition‚ so that’s the more accurate way to view it.
• Others argue that Options Exercisable is better b/c you don’t know whether or not the non-exercisable ones will become exercisable until the acquisition happens.
• However you treat it‚ you need to be consistent with all the companies you analyze.

Question 25

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 $5 each - what is its Diluted Equity Value?

Answer 25

• The Basic Equity Value is $1000 (100 * $10 = $1000). 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 - the share count is now 110 rather than 100.
• However‚ 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 created.
• So the fully diluted share count is 105 and the Diluted Equity Value is $1‚050.

Question 26

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 26

$1000. In this case‚ the options’ exercise price is above the current share price (options are not in-the-money)‚ so they have no dilutive effect.

Question 27

A company has 1M shares outstanding at a value of $100 per share. It also has $10M of convertible bonds‚ with par value of $1000 and a conversion price of $50. How do I calculate diluted shares outstanding?

Answer 27

• First‚ note that these convertible bonds are in-the-money b/c 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 $10M by the par value $1000 to figure out how many individual bonds there are ($10M / $1000 = 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: $1000 / $50 = 20 shares per bond
• So we have 200‚000 new shares (20 * 10‚000) created by the convertibles‚ giving us 1.2M diluted shares outstanding.
• We do not use the Treasury Stock Method with convertibles b/c 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 28

• Let’s say that a company has 10‚000 shares outstanding and a current share price of $20. It also has 100 options outstanding at an exercise price of $10.
• It also has 50 Restricted Stock Units (RSUs) outstanding
• Finally‚ it also has 100 convertible bonds outstanding‚ at a conversion price of $10 and par value of $100.
• What is its Diluted Equity Value?

Answer 28

• First‚ let’s tackle the options outstanding: since they are in-the-money‚ we assume that they get exercised and that 100 new shares get created.
• The company receives 100 * $10 = $1000 in proceeds. Its share price is $20 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 is below the company’s current share price of $20‚ 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 = 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 = $222‚000

Question 29

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 29

• Enterprise Value = Diluted Equity Value - Cash + Debt + Noncontrolling Interest
• Enterprise Value = $222K - $10K + $30K + $15K = $257K