Equity Value, Enterprise Value, Valuation Metrics & Multiples

Question 1

The REAL definition of Enterprise Value is:

Answer 1

“The value of a company’s core business operations to ALL the investors in the company.”

Question 2

What are the key bits of knowledge you should take away from this guide?

Answer 2

• Learn the definitions and how to calc: Enterprise Value (TEV) and Equity value (Eq Val)
• Learn how to bridge from Equity value to Enterprise Value and viceversa
• Learn how to pair Equity value and Enterprise value with operating metrics to create valuation multiples that makes sense
• Be able to explain what happens to Enterprise value and Equity value after specific events

Question 3

Key Rule #1: Equity Value and Enterprise Value: Meaning and Calculations

Answer 3

These concepts go back to that all-important formula:

Company Value = Cash Flow / (Discount Rate – Cash Flow Growth Rate)

where Cash Flow Growth Rate < Discount Rate.

The accounting lessons dealt with the Cash Flow part of that formula.

Equity Value and Enterprise Value deal with the Company Value part.

Specifically, how do you measure “Company Value”? That is tricky to answer because companies are worth different amounts to different types of investors.

Question 4

How do you measure “Company Value”?

Answer 4

This question is tricky because a Company Value is dependent on the investor’s position on the capital stack and their view on the company discount rate/growth rate.

This question is also tricky to answer because “the market” may say a company is worth one amount, but its intrinsic value may be different.

Remember that the intrinsic
Company value can be calculate using the Gordon Growth Model where Company Value = Cash Flow / (Discount rate - Growth Rate)

Different investors can have different views on expected cash flows here yielding different results for the company value.

Question 5

Why does the Gordon Growth model substract the growth rate from the discount rate?

Answer 5

The rationale behind subtracting the growth rate from the discount rate in this formula is:

1) Account for future cash flow growth

If you think about it, what this formula is doing is reducing your required discount rate as you are assuming that there will be growth in the dividends of the company therefore this is a “less risky” investment

Be careful when using massive growth rates because the expectation is that no company can grow faster than the GDP can in perpetuity

Question 6

Why a company’s Market Value often differs from its Implied Value?

Answer 6

You believe the company’s future growth will be one number, but “the market,” or other investors, believe something else.

You might also disagree about the Discount Rate or even the company’s Cash Flow.

All these different views yield different company values.

Question 7

Does “Company Value” refer to just the amount attributable to Equity investors (common shareholders)? Or does it include all the investor groups?

Answer 7

This question creates the main two measurements of “Company Value”:

Equity Value and Enterprise Value.

Equity Value: The value of EVERYTHING a company has (Net Assets, or Total Assets – Total Liabilities), but only to EQUITY INVESTORS (common shareholders).

Enterprise Value: The value of the company’s CORE BUSINESS OPERATIONS (Net Operating Assets, or Operating Assets – Operating Liabilities), but to ALL INVESTORS (Equity, Debt, Preferred, and possibly others).

Question 8

Enterprise Value or Equity Value?

Answer 8

Enterprise Value

Notice that the items in yellow exclude non-operating assets and liabilities such as: cash, debt and equity value

Question 9

Equity value or Enterprise Value?

Answer 9

Equity value. Notice that the items in yellow include all the assets and liabilities and exclude all line items related to Common Shareholder Equity (CSE).

Question 10

People often use Equity Value or Market Cap when discussing company valuations, and journalists usually write about it because it’s simple and easy to calculate. But there is a big problem with it:

Answer 10

if a company’s capital structure (the percentage of Equity vs. Debt) changes, Equity Value will also change!

On the other hand, Enterprise Value will not change – or at least, not change as much – even if the company’s capital structure changes.

Question 11

Does the Enterprise Value of a company change if there is a change in the capital structure?

Answer 11

It does not. This is the reason we often use Enterprise Value when analyzing companies because it lets us reach conclusion of the value of a firm regardless of its capital structure.

Think about the value of a house. The value of a house doesnt change if you finance it with 100% debt or with 100% equity.

Question 12

Why do we pair Total Assets – Total Liabilities with Common Shareholders (Equity Value) and
Operating Assets – Operating Liabilities with All Investors (Enterprise Value)?

Isn’t this pairing arbitrary? If so, couldn’t you create other pairings?

Answer 12

No, it’s not arbitrary. You can understand the pairing with the following logic:

1) A company can generate Equity internally from its Net Income (Net Income flows into Retained Earnings in Common Shareholders’ Equity), but it can also raise Equity from outside investors by issuing stock.

On the other hand, a company cannot generate Debt, Preferred Stock, and other funding sources internally – it must ask outside investors for these funds.

3) A company is unlikely to raise capital from outside investors to acquire Non-Core or Non-Operating Assets, such as a side business selling ice cream if it’s a software company.

4) However, since Equity may be generated internally or raised externally, the company could use it for anything: both Operating Assets and Non-Operating Assets.

So, we pair Enterprise Value with Net Operating Assets and Equity Value with Net Assets.

Question 13

We need both Equity Value and Enterprise Value when analyzing companies because:

Answer 13

1) One analysis might produce the Implied Equity Value, while another might produce the Implied Enterprise Value – and we need to move between them with a “bridge.”

• One example here is that if we run an unlevered DCF for a company we get the Enterprise Value so we need to be able to use this result to calc the Equity Value

2) No single investor group is an island – actions taken by one affect everyone else!

For example, if a company raises Debt, that affects the risk and potential returns for common shareholders as well

Question 14

How do you calculate Equity Value?

Answer 14

There are three main methods you can use to calculate Equity Value

• Method #1: Shares Outstanding * Current Share Price (for publicly traded companies).
• Method #2: Market Value of Total Assets – Market Value of Total Liabilities (technically, “Market Value of Everything on the L&E Side Except for Common Shareholders’ Equity”).
• Method #3: The company’s valuation in its last round of funding, or its valuation in an outside appraisal (for private companies).

We almost always use Method #1 for public companies and Method #3 for private companies because it’s difficult and time-consuming to estimate the Market Value of every single Asset and Liability on the company’s Balance Sheet.

Question 15

How do you calculate Enterprise Value?

Answer 15

Since the starting point for Current Enterprise Value is Current Equity Value, you subtract Non-Operating Assets and add Liability & Equity Items That Represent Other Investor Groups to get to Enterprise Value.

Enterprise Value = Equity Value – Non-Operating Assets + Liability and Equity Items That Represent Other Investor Groups

Enterprise Value: The value of the company’s CORE BUSINESS OPERATIONS (Net Operating Assets, or Operating Assets – Operating Liabilities), but to ALL INVESTORS (Equity, Debt, Preferred, and possibly others).

Written as a formula, the definition would look like this:

• Enterprise Value = (Market Value of Assets – Non-Operating Assets) – (Market Value of Liabilities – Liability and Equity Items That Represent Other Investor Groups)

Rearranging the terms, we get:

Enterprise Value = Market Value of Assets – Market Value of Liabilities – Non-Operating Assets + Liability and Equity Items That Represent Other Investor Groups

Notice how in the formula above the Mkt val of the Assets - the Mkt val of the Liabilities = Equity Value.

Therefore, Enterprise Value = Equity Value - Non-operating assets + Liabilites and Equity Items that represent other groups (debt, pref investors, minority interests)

Question 16

How to think intuitively about Enterprise Value?

Answer 16

TEV (Total Enterprise Value) reflects a company’s overall value to all stakeholders. To calculate TEV:

1.	Identify all claimants - equity investors, preferred equity investors, debt holders, and minority interests. Minority interests arise from consolidation of a firm owning over 50% of another, accounting for the non-owned percentage.
2.	Deduct non-core assets like cash, financial investments, and minority equity investments, since selling these can lower TEV, affecting acquisition costs.

Question 17

What are some examples of non-operating assets a company might have and that we would substract when calculating Enterprise Value?

Answer 17

• Cash, financial investments (stocks, bond holdings), side business unrelated to the core business, property that generates rental income and its not used in core business lines, equity invesments in other companies for less than <50% (minority investments), assets held for sale, net operating losses). In summary, an asset is non-core if the company doesnt need it to sell a product or service.
• Cash (Technically, some amount of Cash is always operational because companies need a minimum amount to pay for the day-to-day running of the business. However, this minimum amount varies widely between different companies and industries, so the standard treatment is to simplify it and assume that all Cash is “Non-Operating.” Doing so also makes it easier to compare companies and get a quick read of each company’s valuation.)
• Financial Investments, such as stocks and bonds.

Owned Properties from which the company earns rental income (rather than using the properties internally and generating no income from them).

• Side Businesses that earn income for the company (e.g., an ice cream or Japanese whiskey business owned by a software company).
• Assets Held for Sale and Assets Associated with Discontinued Operations.
• Equity Investments or Associate Companies, which represent minority stakes in other companies (the Parent Company owns < 50% of these other companies).
• Net Operating Losses (NOLs), which are a component of the Deferred Tax Asset.

In summary, an Asset is Non-Core or Non-Operating if the company does not need that Asset to sell products/services and deliver them to customers.

Question 18

What do you do with Liability & Equity Line Items That Represent Other Investor Groups when moving from equity value to Enterprise value?

Answer 18

You add them. Think about the fact that you are tyring to estimate the value of the company to ALL its investors.

Other items in this category include:

• Capital Leases – Debt-like obligations with Interest payments that are used specifically to acquire plants, property, and equipment (PP&E).
• Noncontrolling Interests – These represent the unowned portions of majority-owned companies.

If Company A owns 80% of Company B, it will consolidate Company B’s financials with its own but also record a Noncontrolling Interest for the 20% of Company B that it does not own.

• Unfunded Pensions – If a company has a defined-benefit pension, meaning it’s required to pay retired employees a fixed amount each year, then it will have Pension Assets and Pension Liabilities. Pension Assets represent the investments set aside for these retirement payments, and Pension Liabilities represent the Present Value of the expected future obligations. If the Liabilities exceed the Assets, the pension is unfunded, and only that portion (Pension Liabilities – Pension Assets) should be added in the Enterprise Value bridge.
  The employees act as “another investor group” in this case. In exchange for lower salaries/benefits in the present, they accept promised payments from the company once they retire. It’s similar to Debt, but over a much longer-term time frame.

*(Potentially) Operating Leases – In 2019, the accounting rules for Operating Leases changed, and they now appear on-Balance Sheet. Under IFRS, you normally add them when calculating Enterprise Value because of how the lease expense is presented on the Income Statement, but under U.S. GAAP, it could go either way as long as you’re consistent with the valuation multiples.

Question 19

Why do non-controlling interest count as another investor group when calculating Enterprise Value?

Answer 19

These count as “another investor group” because if a company owns more than 50% of another company, it has effective control of that other company and can draw on all its resources, including those linked to the minority shareholders of this other company.

You also count these in Enterprise Value for comparability purposes

Question 20

Equity Value and Enterprise Value: Implications

Answer 20

The definitions of Equity Value and Enterprise Value have far-reaching implications.

Implication #1: Current Equity Value Cannot Be Negative, But Current Enterprise Value Can Be Negative

A company’s Current Share Price cannot be negative, and its Share Count also cannot be negative. So, it’s mathematically impossible for Current Equity Value to be negative.

Yes, Net Assets on the Balance Sheet could be negative, but the Market Value of Net Assets is extremely unlikely to be negative unless it’s a distressed company.

On the other hand, Current Enterprise Value could easily be negative.

For example, what if the company’s Current Equity Value is $100 million, but it has $200 million in Cash and no Debt?

Its Current Enterprise Value is negative $100 million.

This scenario is rare; it’s most common for pre-bankruptcy companies that are burning through cash at high rates and that are likely to die soon.

A Negative Enterprise Value lets you buy Cash at a discount… assuming the company survives!

Implication #2: Both the IMPLIED Equity Value and IMPLIED Enterprise Value Can Be Negative

As a simple example, if a company’s Cash Flow to ALL inveestors is currently negative $100, and the Discount Rate is 3%, with a Cash Flow Growth Rate of 2%: Company Value = ($100) / (3% – 2%) = ($10,000)

If the company has $500 in Cash and no Debt, then its Implied Equity Value will also be negative.

You back into Implied Equity Value in this case, so there’s no reason why it can’t be negative.

While this scenario is THEORETICALLY possible, it’s extremely unlikely in real life unless you’re analyzing distressed or highly speculative companies (e.g., tech or biotech startups).

So, if you got this result in a valuation, you might just set the Implied Share Price to $0.00 and assume the company is worthless.

Implication #3: IN THEORY, Financing Events Do Not Affect Enterprise Value; Only Changes to the Company’s Core Business (i.e., Net Operating Assets) Affect Enterprise Value

Question 21

If a company with an Equity Value of $1,000 and Enterprise Value of $1,200 issues $100 of Common Stock, what happens to both Enterprise Value and Equity Value metrics?

Answer 21

If a company issues a $100 of common stock Equity Value increases by $100 on the L&E side. Therefore, the new Equity Value is $1,100.

The stock sale results in $100 additional Cash on the assets side. Given that cash is a non-operating asset the Enterprise Value remains at $1,200

Question 22

True or false: IN THEORY, Financing Events Do Not Affect Enterprise Value

Answer 22

True. Here are a few examples why financing events do not affect Enterprise Value accorrding to the Modigliani-Miller theorem:

• Issuing debt: cash and debt both increase and offset each other
• Repaying debt: cash and debt both decrease and offset each other
• Issuing stock: cash and equity value both increase and offset each other
• Repurchasing shares: Cash and Equity value both decrease and offset each other

Issuing dividends: cash and equity value decrease and offset each other

In these examples, there’s also a much simpler explanation: Net Operating Assets do not change. Cash, Debt, and Common Stock are all Non-Operating in nature.

Question 23

True or False: Enterprise Value changes only if a company’s Net Operating Assets (i.e its core business operations changes)

Answer 23

True.

Here are a few examples where your Enterprise Value would change. Assuming cash on the Asset side balances the change:

• PP&E increase: PP&E is an operating asset. Increase in PP&E with no operating liabilities change means Net Operating Asset increase therefore Enterprise Value increases
• Inventory Increases: Inventory is an operating asset. Increase in Invenotry with no operating liabilities change means Net Operating Asset increase therefore Enterprise Value increases
• Accounts Receivable Decreases (due to cash collection): AR is also an Operating Asset, and no Operating Liabilities change. NOA decreases, so Enterprise Value decreases.
• Deferred Revenue Increases: This is an Operating Liability. No Operating Assets change, so when Deferred Revenue goes up, NOA goes down. Therefore, Enterprise Value decreases.

In these specific examples, Equity Value does not change because Cash, not Common Shareholders’ Equity, balances each change.

However, if these changes had been funded by a Stock Issuance or something else that affected Common Shareholders’ Equity, then Equity Value would have changed.

Question 24

Equity Value changes only if Common Shareholders’ Equity changes

Answer 24

True. If it does, both CSE and Equity Value change by the same amount

Question 25

Enterprise Value changes only if Net Operating Assets changes

Answer 25

if it does, both NOA and TEV change by the same amount

Question 26

MYTH #1: Enterprise Value is the “Cost to Acquire a Company”

Answer 26

False. Enterprise Value is the value of a company’s core business operations to all the investors in the company.

When a company wants to acquire 100% of another company, at the minimum, it must pay for all the other company’s shares outstanding.

So, the minimum purchase price is the other company’s Equity Value.

Past that, it gets tricky because not all acquisitions treat Debt and Cash the same way.

In most cases, the seller’s Debt must be “refinanced” (i.e., replaced with new Debt, or completely repaid) in an acquisition.

However, this same condition isn’t necessarily true of the other Debt-like items that you add when moving from Equity Value to Enterprise Value. And if the buyer simply replaces the seller’s Debt with new Debt, is the buyer really “paying” for the seller’s Debt?

Also, the acquirer doesn’t necessarily “get” all the seller’s Cash for itself because the seller still needs a certain amount for day-to-day operations.

Finally, the acquirer may have to pay additional fees to close the deal, and these fees are not reflected in the seller’s Enterprise Value at all.

Question 27

MYTH #2: Enterprise Value is the “True Value” of a Company

Answer 27

This statement might seem true at first, but it’s missing one critical component: to whom?

Enterprise Value might be the “true value” of a company to all the investors in aggregate, but if you’re a common shareholder, it’s certainly not the company’s true value to you.

Going back to the home-buying analogy with the $250K mortgage and $250K down payment, how much is that new house worth to you?

You might be tempted to say, “$500K,” but think about what would happen if you tried to sell the house right after you bought it.

You’d only get $250K in proceeds because you’d have to repay the $250K mortgage. Even if the home sells for $500K total, you only get $250K from the sale.

Question 28

MYTH #3: Debt “Adds” to Enterprise Value, and Cash “Subtracts” from Enterprise Value

Answer 28

No, no, and no.

Debt doesn’t “add to” a company’s Enterprise Value.

You add Debt when you move from a company’s Equity Value to its Enterprise Value.

Similarly, Cash doesn’t “subtract from” a company’s Enterprise Value.

You subtract Cash when you move from a company’s Equity Value to its Enterprise Value.

This distinction may seem trivial, but the difference is huge.

If you say that Debt “adds to” Enterprise Value, you’re implying that Debt issuances can change a company’s Enterprise Value – which is not true!

If you get this distinction wrong, you’ll incorrectly think that simple issuances of Debt and Equity change a company’s Enterprise Value. But they do not.

Only changes to a company’s core business affect its Enterprise Value.

Question 29

MYTH #4: You Subtract Cash When Calculating Enterprise Value Because It’s “The Opposite” of Debt

Answer 29

No, no, no, and no.

You subtract Cash when moving from Equity Value to Enterprise Value because Cash it is a Non-Operating or Non-Core Asset.

In other words, the company doesn’t need its full Cash balance to continue selling/delivering products and services to customers. On the other hand, it does need its Inventory and its PP&E to keep doing these activities – so you don’t add or subtract those items. Technically, you should subtract only the excess Cash balance, but in practice, everyone simplifies this and subtracts the entire balance. Finally, there’s another reason why Cash is not “the opposite” of Debt: many forms of Debt do not allow early repayment. Even if a company has a huge Cash balance, it can’t necessarily use it to repay Debt.

Question 30

Key Rule #2: How Events Impact Equity Value and Enterprise Value

Answer 30

Common interview questions about Enterprise Value and Equity Value include the following:

• “What happens to a company’s Enterprise Value if it raises $100 of Debt?”
• “What happens to a company’s Equity Value if it issues $100 in Dividends?”
• “A company has excess Cash. How do its Equity Value and Enterprise Value change if it chooses to repurchase Stock vs. repay Debt?”
• “A CEO finds $100 of Cash on the street and adds it to the company’s bank account. How do Equity Value and Enterprise Value change?

These questions always refer to the Current Equity Value and Current Enterprise Value, so you only think about changes to the company’s Balance Sheet – not its future cash flows. You can answer 99% of these questions with a simple, 2-step process:

1) Does Common Shareholders’ Equity (CSE) change?

If so, then Equity Value changes by the amount that CSE changes. If not, then Equity Value does not change. You can also think of this as, “Do Net Assets change?” but be careful because if there are Noncontrolling Interests or Preferred Stock, Net Assets no longer equals CSE!

Items that affect CSE include Net Income, Dividends, Stock Issuances, and Stock Repurchases.

2) Do Net Operating Assets (NOA) change?

If so, then Enterprise Value will change by the amount that NOA changes. It doesn’t matter which investor group was responsible because Enterprise Value reflects all investors

Question 31

How capital structure changes impact TEV and Eq Val?

Answer 31

Single-step changes here are fairly simple, but multi-step ones can be tricky.

It’s easiest to think about the net effect on CSE and NOA rather than explaining each step in the process.

Question 32

How capital structure changes impact TEV and Eq Val?

• Company Issues $100 of Common Stock and Does Nothing With It

Answer 32

Eq Val increases by $100, and TEV stays the same.

Question 33

How capital structure changes impact TEV and Eq Val?

• Company Issues $100 of Common Stock and Uses the Proceeds to Issue $50 of Dividends

Answer 33

Eq Val: Issuance of $100 of stock increases equity value by $100. $50 div payment reduces cash by $50 and Eq Val by $50. Leaving the Eq Val up by $50.

TEV: does not increase as the stock proceeds go into cash and cash is a NOA. The issuance of dividend is paid with cash and cash is NOA. Therefore, TEV does not change.

Question 34

How capital structure changes impact TEV and Eq Val?

• Company Issues $100 of Common Stock to Fund a $100 Acquisition

Answer 34

Does Eq Val change: Yes, because the issuance of $100 stock increase CSE by $100.

Does TEV change?: Issuance of stock does not change TEV but given that the proceeds are used to fund an operational acquisition TEV does change by $100

Question 35

How capital structure changes impact TEV and Eq Val?

• Company Issues $100 of Debt

Answer 35

Nothing changes because debt issuance doesn’t impact CSE nor NOA

Question 36

How capital structure changes impact TEV and Eq Val?

• Company Issues $100 of Debt to fund $100 of stock repurchase?

Answer 36

Does Eq Val change: Yes, because the debt proceeds are used to repurchase stock. Therefore, Eq Val is ($100).

Does TEV change?: No because nothing that changes here (debt, cash and equity) is an operating asset or liability therefore TEV stays the same.