Equity Value and Enterprise Value: The Complete Guide
Equity Value and Enterprise Value are technical topics that almost every would-be investment banker gets wrong.
So much so, that if I were giving a rigorous technical test to IB/PE interview candidates, I would base 100% of my questions on these two concepts.
Because there are so many terrible explanations that questions based on Equity Value and Enterprise Value are a great way for investment banks to find the best candidates.
Equity Value and Enterprise Value Explained
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 Discounted Cash Flow (DCF) Analysis; 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.
- 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?
- Does “Company Value” include all the company’s Assets or just those related to its core business?
- Does “Company Value” mean “value to all investors,” or just to certain investors?
Because of the first point – 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 points – the Assets and investors we’re including – explain the origins of Equity Value and Enterprise Value:
- Equity Value Definition: The value of ALL the company’s Assets, but only to EQUITY INVESTORS (common shareholders).
- Enterprise Value Definition: 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.
- 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.
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 are the types of investment banking interview questions that are often asked of candidates:
- 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:
For 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:
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?
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