By Victor Paquet (Mergersight Operations) and Carlo Leopardi & Tommaso Arona (Boston University partners)
Walkthrough
Enterprise Value
Enterprise value (EV), or Total Enterprise Value (TEV), is the value of a company’s core business operations that is available to both equity and debt shareholders. It is an important metric in M&A, as it tells the acquirer the value of its target. Enterprise value thus becomes an important measure for various valuation methodologies including trading multiples like EV/Revenue, EV/EBITDA, and EV/Sales. To calculate enterprise value from equity value, subtract cash and cash equivalents and add debt, preferred stock, and non-controlling interest.
N.B: Despite that you can abbreviate both Equity and Enterprise Value as “EV”, “EV” stated on its own will always refer to the Enterprise Value
Equity Value
The equity value of a company is equal to its market capitalization. Market capitalization, or market cap, is the current market value of the company’s outstanding shares. Mathematically, it is the price per share times the # of shares outstanding. It dictates the total value of the company that is attributable to equity investors. Thus, equity value is the basis for various valuation methodologies including trading multiples like P/E and Price/Book Value. Note that the market equity value of a company is not the same as its book equity value, which stated on the balance sheet as the difference between assets and liabilities.
Equity Vs. Enterprise Value
Both measures are utilized in various valuation methodologies. When deciding which one to use, opt for equity value if your metric involves changes in debt and interest. Alternatively, choose enterprise value if it excludes changes in debt and interest. The rationale for using enterprise value before deducting any interest or debt lies in the fact that this cash flow is available to both debt and equity shareholders, unlike equity value which is only available for equity shareholders.
Therefore, there are differences when discounting future cash flows to their present values. Discounting levered free cash flows (cash flow available to only equity shareholders) is done by using the cost of equity, as the calculation only concerns equity investors. In contrast, when calculating enterprise value, unlevered free cash flows (cash flow available to both debt and equity shareholders) are discounted by Weighted Average Cost of Capital (WACC) as now the calculation includes all investors.
Enterprise value and its multiples are vastly more used for valuation as a multiple like P/E is not capital neutral, making it hard to compare companies. However, there may be some industries where the P/E ratio and equity value are more meaningful than enterprise value and its multiples. For example, when valuing banks, financial institutions, or insurance firms P/E might be preferred as these companies use debt differently than other companies and interest is a major component of a bank’s revenue.
Outstanding Debt
A company’s total debt is all the money it owes to lenders or creditors. This includes both short- and long-term debt appearing on the balance sheet as liabilities. We add this amount to the EV calculation because when the acquirer acquires the target it takes on the existing debt of the target, increasing the cost of the acquisition.
Cash & Cash Equivalents
We subtract this amount from EV because it will reduce the acquiring costs of the target company. This is because the acquirer will use the cash immediately to pay off a portion of the theoretical takeover price. Specifically, it would be immediately used to pay a dividend or buy back debt.
Non-Controlling Interest
A non-controlling interest, or a minority interest, pertains to a circumstance when a company possesses a minority stake in another company, or a stake that controls less than 50% of a company's total shares. The financial statements of this subsidiary are consolidated in the financial results of the parent company. Thus, we need to add this noncontrolling interest to the EV calculation as the parent company includes 100% of the revenues, expenses, and cash flow in its numbers even though it doesn’t own 100% of the business.
Preferred Stocks
Preferred stocks are a type of stock that have features of both equity and debt. In contrast to common stock, they are treated more as debt because they pay a fixed amount of dividends, are higher on the capital structure, and have higher earning claims than common stock shareholders. In an acquisition, they normally must be repaid just like debt. Thus, we need to add preferred stock in the EV calculation.