So before someone goes from 0 to 60 and is asked about more advanced valuation concepts, we are going to discuss it here in very simple terms so that eager beavers can learn to walk before they run.
Understanding Enterprise Value and Equity Market Value
Enterprise Value (“EV”) is the value of the entire company. Market Capitalization/Equity Value/Equity Market Value is the value attributable to common equityholders – or the stockholder. When you own a stock, you have a claim to the equity value.
When companies are publicly traded like Kraft Heinz (KHC) or Universal Display (OLED), the equity market value is easy to ascertain. You simply multiply the ownership stakes (the number of shares, which you would grab from the company’s latest 10-K, 10-Q or other disclosure) with the current market price – or the stock price that is being traded on an exchange.(1)
For private companies, more work needs to be done to solve for an implied equity value.(2)
Generally speaking, the difference between enterprise value and equity value is net debt.
Enterprise Value = Equity Value + Net Debt
Enterprise Value – Net Debt = Equity Value
EV – Debt = EMV
Theoretically, if a company was worth $1,000 and there is a $300 million loan outstanding to the bank, $700 is the equity value. If you sold the company for $1,000 – the bank needs to be paid first – it is more senior in the capital structure, so $1,000 – $300 = $700.
Now you will notice that we reference Net Debt instead of Debt. This means debt net of cash.
EV = Debt – Cash + Equity
So if a company has $100 of cash, the mathematical identity implies that the EV is $100 lower. This is confusing to some people – how can cash in a company reduce the value of the enterprise?
Looking at it another way, if you were to buy a company worth $1,000 before the cash and there was $100 of cash on the balance sheet, you could use the $100 in cash to pay for some of it. More intuitively though, the existence of cash to offset debt means that the equity value must be higher.
Why Enterprise Value is Important for Investment Banking
EV is the foundation of valuation. When we are looking at what something is worth, we are looking at the EV – and this is before capital structure effects. This is key – enterprise value is an asset value, before the effects of leverage (and accordingly interest) or how you finance the asset.
The simplest example is a house. Ignoring taxes, if a house is worth $1 million, whether it is 100% owned by the equity owner (paid all cash or paid down the mortgage) or has a $500,000 mortgage, the value of the house is still $1 million.
EV as a concept is straightforward – it is getting to the right EV which is where the investment banker’s job begins.
As we discuss in our investment banking interview walkthrough, there are many valuation methods, with the most common being:
- Discounted Cash Flow (DCF)
- Comparable Company Multiples
- Precedent Transaction Multiples
- Leveraged Buyout
- Liquidation Value
- Sum of the Parts (which can be a blend of all of the above)
All of these can get an investment analyst to enterprise value. The question is what multiples or cash flows to use in solving for this number.
The first consideration is choosing the appropriate comparison. EV goes with EBITDA and Market Capitalization or Equity Value goes with net income because these are the cash flows that are available to the appropriate stakeholders. EV represents all of the stakeholders of the firm.
As such EBITDA, being a pre-leverage number, will include the monies that are owed to the debt holders as well. Net income is after interest and taxes (both which depend on how management chooses to capitalize a company) – as such, this is after bondholders have been paid off. Net income is relevant to shareholders.
Similarly, unlevered free cash flow is used for discounting cash flows to get to enterprise value.
Unlevered free cash flow = Net Income + Non Cash Charges (including depreciation) + Interest (1 – Corporate Tax) – Capital Expenditures – Change in Net Working Capital
For an equity value discounted cash flow (which are rare outside of financial institutions), the appropriate cash flow to use is levered free cash flow.
Levered free cash flow = unlevered free cash flow – interest (1- corporate tax) + net debt issuance
Stretching the Enterprise Value Calculation
In a much more theoretical valuation, the logic that applies to net debt and equity would flow through to all the other claims that are included in a corporation.
Enterprise Value = Equity + Debt – Cash + Preferred Shares + Capitalized Operating Leases(3) + Pension Obligations + Subordinated Debt/Mezzanine Financing/Hybrid Debt – Investments + Minority/Non-Controlling Interest – Equity Affiliates + Asset Retirement Obligations
Similar to the theory above, anything that is debt-like in structure or represents a claim that competes with equity holders will add to the enterprise value.
1. You would also adjust this for dilutive securities. As part of stock-based compensation incentives for management, key employees and otherwise, there may be physically settled options that can dilute the ownership of the basic shareholders. As such, if employees are paid partially with ownership interests, a shareholder that owns 10% of the shares of the company would own less on a fully diluted basis. Please refer to our interview guide on how to get to fully diluted shares outstanding.
2. A “Grey” market exists for privately held companies where private shareholders may look to sell their stakes via a broker to another private party. These markets are extremely illiquid but can give a reference point to value.
3. Capitalized leases are already counted as debt – as investment bankers view leasing as a financial decision, a company’s rent or operating lease payments should be multiplied by an industry relevant multiple or be present valued to reflect the financial obligation