## Equity Value and Enterprise Value: The First, Last, and Only Guide You’ll Need to Master These Concepts

*everyone*is wrong about?

You might think of many examples if you limit yourself to politics and religion, but “mass wrongness” also extends into **technical questions** in investment banking interviews.

Some sources have spotty coverage of accounting, valuation, and M&A analysis, but no one is completely wrong about those topics.

But it’s a different story with **Equity Value and Enterprise Value**.

If I were giving a rigorous technical test to IB/PE interview candidates, I would base 100% of my questions on these concepts.

Why?

Because there are *so many* terrible explanations that questions based on Equity Value and Enterprise Value are a great way to find the best candidates:

**Your Free 94-Page Guide to Equity Value and Enterprise Value**

I’ll avoid a lengthy preamble here and give you what you’re looking for below:

- Equity Value, Enterprise Value, and Valuation Multiples – Written Guide (PDF)
- Excel Examples for Equity Value and Enterprise Value

If that’s too long, you can get the summary version below:

**The Real Definitions of Equity Value and Enterprise Value**

Both of these terms relate to a **company’s** **value**.

You can estimate “company value” with this formula:

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

It’s the same formula used for Terminal Value in a DCF; in real life, we have to create a DCF instead of using this single formula because a company’s Growth Rate, Discount Rate, and Cash Flow *change* over time.

A company with higher Cash Flow is worth more than one with lower Cash Flow.

A company with higher Cash Flow Growth is also worth more.

And a company is also worth more if the Discount Rate is lower, i.e. *you are targeting lower returns*.

For simple, back-of-the-envelope calculations, this formula is a good way to estimate the value of an asset or company.

But past a certain point, **you must be more specific about what “Company Value” means.**

For example, does it refer to what *the market as a whole* believes a company is worth?

Or does it refer to *our opinion *of what the company is worth?

And does “Company Value” include all the company’s Assets or just those related to its core business?

Finally, does “Company Value” mean “value to *all* investors,” or just to *certain* investors?

Because of the first issue – the market’s views vs. our own – we split “Company Value” into Current Value and Implied Value:

**Current Value:**What “the market as a whole” believes the company is worth. If the company is public, its share price reflects this amount. If the company is private, silly venture capitalists pouring money into a Ponzi scheme (Uber) reflect this amount.**Implied Value:**What*you*believe the company is worth. This figure reflects*your view*of the company’s Cash Flow, Discount Rate, and Cash Flow Growth Rate based on your expectations.

The second and third issues – the Assets and investors we’re including – explain the origins of **Equity Value** and **Enterprise Value:**

**Equity Value:**The value of**ALL**the company’s Assets, but only to**EQUITY INVESTORS**(common shareholders).**Enterprise Value:**The value of only the company’s**core-business Assets**, but to**ALL INVESTORS**(Equity, Debt, Preferred, and possibly others).

You can calculate a single company’s Current Equity Value, Current Enterprise Value, Implied Equity Value, and Implied Enterprise Value.

They each mean something slightly different, and you’ll almost always calculate all of them when valuing or modeling a company.

To move *from* a company’s Equity Value *to* its Enterprise Value, use both parts of the two definitions above:

**Equity Value**= Value of Core-Business Assets + Value of Non-Core-Business Assets**Enterprise Value**= Value of Core-Business Assets

Therefore, you subtract non-core-business Assets (Cash, Investments, Associate Companies, and anything else unrelated to the company’s operations) as the first step in this move.

Then:

**Equity Value**= Value to Equity Investors**Enterprise Value**= Value to Equity Investors + Value to Debt Investors + Value to Preferred Investors (and possibly others)

Therefore, you add Liability & Equity line items that represent other investor groups as the second step in this move.

The most common items are Debt, Preferred Stock, and Noncontrolling Interests, but there are others, such as Unfunded Pensions, as well.

Here’s a simple example:

Here’s the “Equity Value” view of Coach’s Balance Sheet:

To move from Equity Value to Enterprise Value, you subtract the non-core-business Assets: Cash, Short-Term Investments, and Long-Term Investments.

And on the other side of the Balance Sheet, you add Debt and Preferred Stock since they represent other investor groups:

Neither Equity Value nor Enterprise Value is “correct”; they’re just different.

**The Implications of These Definitions: Why Enterprise Value Matters**

There are a few important implications of these definitions:

**Implication #1: In Theory, Financing Events Will Not Affect Enterprise Value, But They May Affect Equity Value**

These types of questions are common in interviews:

- A company issues $500 in Dividends. What happens to its Equity Value and Enterprise Value?
- A company raises $1,000 of Debt to repurchase Stock. What happens to its Equity Value and Enterprise Value?
- A company repurchases $700 of Stock using Cash. What happens to its Equity Value and Enterprise Value?

The *worst* way to answer these questions is to use the standard formula for Enterprise Value: Equity Value – Cash/Investments + Debt + Preferred Stock + Noncontrolling Interests.

That formula will make it **very** confusing because you have to think about whether or not each item changes.

Instead, use this 2-step process to decide on what changes:

**Step 1: What is responsible for this change? Something related to the company’s Common Equity (a stock issuance, repurchase, dividends, etc.), or something else?**

If the answer is “something related to the company’s Common Equity,” then Equity Value **will change**.

If the answer is “something else,” then Equity Value will **not** change.

**Step 2: Does a core-business Asset change?**

If so, Enterprise Value will change.

If not, Enterprise Value will not change.

**Example #1:** A company issues $200 of common shares to acquire $200 in PP&E.

**Step 1:** A common stock issuance is responsible for this increase in PP&E. Therefore, Equity Value increases by $200.

**Step 2:** PP&E is a core-business Asset. Therefore, Enterprise Value increases by $200.

**Example #2:** A company uses $100 of Cash to repay $100 in Debt.

**Step 1:** A common stock issuance was not responsible for this change. It involved Cash and Debt, not stock. Therefore, Equity Value stays the same.

**Step 2:** Cash is not a core-business Asset. Therefore, Enterprise Value stays the same.

**Example #3:** A company issues $200 of common shares. It acquires another company for $100 and leaves $100 in Cash on its Balance Sheet.

**Step 1:** A common stock issuance was responsible for this change. Therefore, Equity Value increases by $200.

**Step 2:** The other company is a core-business Asset, but Cash is not. Therefore, Enterprise Value increases by $100.

**Implication #2: In Theory, Only Changes to a Company’s Core Business Will Affect Enterprise Value**

For example, all of the following changes might affect a company’s Current and Implied Enterprise Value:

**Example 1:**The company wins a major contract with a new customer, boosting its expected future Revenue and, therefore, its future Cash Flow.**Example 2:**The company closes down an unprofitable division, boosting its margins and its expected future Cash Flow.**Example 3:**The company negotiates a better supplier contract, boosting its margins and its expected future Cash Flow.

These changes will affect Enterprise Value because:

- They change the company’s expected future cash flow from its
**core business**. - They do
**NOT**change the cash flow just for one group of investors.**All**the investors are affected.

Only changes to a company’s core business affect its Enterprise Value, but *both* financial and operational changes affect its Equity Value.

If you’re wondering about the PP&E example above, $200 of additional PP&E will boost the company’s Enterprise Value by $200 because:

- In the long term, that PP&E will generate additional cash flow for the company’s
**core business**. - This additional cash flow will be available to
**all**the investors in the company.

**Implication #3: Metrics That Represent ONLY Equity Investors Pair with Equity Value, and Metrics That Represent ALL Investors Pair with Enterprise Value**

For this rule, it’s helpful to think about “who gets paid” at each step along a company’s Income Statement.

Initially, a company’s Revenue, Gross Profit, and Operating Income are available to **all investors in the company**.

When those increase, everyone benefits.

For example, higher Revenue makes it easier for the company to pay interest on Debt, Preferred Dividends, and Common Dividends.

But as you move down the Income Statement, you start eliminating different investor groups as they “get paid.”

Also, you start to reflect income and expenses from non-core-business Assets:

If a metric is *before* Interest Expense and Preferred Dividends have been subtracted, then you pair it with **Enterprise Value**.

If a metric is *after* Interest Expense and Preferred Dividends have been subtracted, then you pair it with **Equity Value**.

Common metrics that pair with **Enterprise Value** include Revenue, Operating Income or EBIT, NOPAT, EBITDA, and Free Cash Flow to Firm (i.e., recurring cash flow available to all investors).

Common metrics that pair with **Equity Value** include Net Income or Net Income to Common, Free Cash Flow, and Free Cash Flow to Equity.

**Why Enterprise Value is a Pink Unicorn**

Everything above represents a theoretical view of Enterprise Value: That it’s truly “capital structure-neutral,” and that only changes to a company’s core business affect it.

This graph represents that same theoretical view:

**a company’s capital structure**because of taxes, bankruptcy risk, and agency costs.

*does*affect its valueFor example, at first, additional Debt helps a company Debt is cheaper than Equity and Preferred Stock (due to the tax-deductible interest, among other factors).

But Debt starts hurting the company past a certain point because the bankruptcy risk climbs to a much higher level, and there’s a higher chance of conflict between the different investor groups (“agency costs”).

So, this graph is a more accurate depiction of a company’s Enterprise Value as its capital structure changes:

*Implied*Enterprise Value than

*Current*Enterprise Value.

If a company raises more Debt, its Current Enterprise Value will probably *not* change overnight.

But if it is expected to have more Debt permanently, its Current Enterprise Value will start to change.

The bottom line is that Enterprise Value is **not** truly “capital structure-neutral,” as some sources claim.

It’s better to think about the concept like this: “Changes to a company’s capital structure tend to affect the company’s Equity Value by *more* than they affect its Enterprise Value.”

Finally, there’s ambiguity in the Enterprise Value calculations because not everyone agrees on what constitutes a “core-business Asset” or an “investor group.”

As a result, there are disagreements over how to treat certain, more advanced items that go into the calculation.

My advice is to focus on the basic items that everyone can agree on – Cash, Debt, Preferred Stock, and so on – as well as common transactions that affect those items.

**Challenge Round: Test Yourself**

So, how well do you understand these concepts?

To test yourself, answer these questions on Equity Value and Enterprise Value:

- Explain why you add Unfunded Pensions when moving from Equity Value to Enterprise Value. Also, explain the tax treatment.
- Explain
**INTUITIVELY**how Implied Enterprise Value might be negative. Your answer should be 1-2 sentences, and it should not include any formulas or numbers. - A CEO picks up $200 in Cash on the street and adds it to the company’s bank account. Explain what happens to Equity Value and Enterprise Value
*using the “2-step rule” for changes.***Hint:**Think about how you would record this transaction on all three financial statements. - A company generates $100 in Net Income. Does its Enterprise Value change? If so, what is the intuition behind it? If not, what would cause it to change?

**NOTE:** You won’t find the exact answers to these questions in the guide. But I may answer them in the comments, depending on the quality of your responses.

Good luck!

- Equity Value, Enterprise Value, and Valuation Multiples – Written Guide (PDF)
- Excel Examples for Equity Value and Enterprise Value

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**Week 1:**How to Tell Your Story Like a Pro in 2017 – The Streamlined Version**Week 2:**Equity Value and Enterprise Value: The First, Last, and Only Guide You’ll Need to Master These Concepts**Week 3:**How to Prepare Efficiently for “Fit” Questions**Week 4:**Case Study Prep and Putting It All Together

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### Comments

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I must say that you brilliantly explained this way better than my university institution have ever managed to do (especially the MM theorem part). I guess sometimes a less academic approach to explain complex problems is good for understanding the whole picture!

Cheers.

So, in a DCF calculation, using levered cash flow returns equity value and unlevered cash flow returns enterprise value? Assuming that’s correct, then if you subtracted debt from the enterprise value you’d get to equity value and in the equity value scenario you don’t need to subtract debt because that has already been factored in?

In terms of the fourth question at the end, would the answer be the unchanged for enterprise value? Since the caah increased from net income will be cancelled out by concluding the cash.

Yes, but there’s a more intuitive explanation for why Enterprise Value remains unchanged.

Brian,

I´ve seen and heard of bankers here in Brazil moving from EV to Equity Value by also adding Net Working Capital (e.g. Inventory + Receivables – Payables), for the RETAIL sector.

The theory is they se how much the current NWC exceeds its historical avarage and add that difference, but in practice they just add LTM Inv. and Receivables and subtract Payables.

This happened both at a buldge bracket I did an internship at and at a friend´s boutique.

Am I wrong to assume this can´t be done, since you already factor in NWC in your future free cash flows when calculating Enterprise Value? Is this just creative accouting for boosting Valuation, which ironically can backfire if the NWC is negative? Or am I missing something here?

That seems very questionable to me. Working Capital is always related to the company’s operations, so it should not differ between Equity Value and Enterprise Value (and it’s already factored into Free Cash Flow used to calculate the implied version of either one). It seems like a way to artificially boost a company’s value with thin justification.

Hi Brian,

I’ve encountered a company with interesting balance sheet items and this gives the calculation of EV some difficulties. The company is called Aimia Inc. (TSX:AIM). It’s the owner and operator of several frequent flyer loyalty programs (including Aeroplan in Canada). It has large amount of redemption liabilities on its balance sheet. My question is, should you include the redemption liability in its EV?

What’s more confusing is that the company is required to hold cash reserves on the balance sheet against the redemption liabilities (but it only covers the small fraction of the redemption liability, the thinking is that the ongoing cash flow generated will cover most of the redemption liabilities). My question is, should I include this cash reserve in my net debt calculation?

Thank you for your insights.

Best,

Jason

If this redemption liability is operational i.e. it is something that the company plans to pay out to customers in the future, it does not represent another investor group and should not be added when calculating Enterprise Value. You typically count all Cash as a non-core Asset and subtract it, even though that is not quite accurate since all companies need a minimum Cash balance to keep operating (and since some companies may keep reserves for various purposes).

Brian,

How would you overcome an issue of changing capital structure when trying to find WACC? Assume we are not provided with a target capital structure of the company.

Is it correct to use industry average capital structure to find wacc? I don’t think it is appropriate to use current capital structure of the company, as it is changing and wacc is used to discount future cashflows with different capital structures.

Change the Discount Rate each year and make it move closer to the one represented by the company’s long-term capital structure goal (e.g., 8% current Discount Rate to 10% target over 10 years – make it go up by 0.2% each year). If you don’t have the company’s target, take the median capital structure percentages from the comparables.

Good article.

Enterprise value: Market Cap + Net Debt (short term + long term + pref stock – cash)

Equity value: Enterprise value – debt

Correct?

No. See Key Rule #7 in the guide. To move *from* Enterprise Value to Equity Value, you have to do the reverse and add non-core Assets and subtract items that represent other investor groups. So your equation is missing several terms.

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

Company Value = $100 / (2% – 3%) = –$10,000

Assuming that this is the cash flow to ALL investors and that the Discount Rate is WACC, then

the company’s Implied Enterprise Value is negative $10,000.”

This is incorrect. You cannot have a (perpetual) growth rate larger than your required rate of return. As your growth rate approaches your req. rate, the implied value of your firm is infinite, but then flips negative as you grow faster than the rate required to invest? Of course not. This model works only for all r>g.

Thanks for pointing that out. Yes, that was fixed in an earlier version. Somehow an older version was posted, so we just replaced it and changed that example.

Worth to mention that when finding terminal value, growth rate used should be average predicted GDP growth rate of that country (in accordance to the mean reversion theory). In reality, most analysts use a combination of predicted inflation rates and predicted gdp growth rates to find g in the formula.