Introduction to Enterprise value and Equity Value
Enterprise value is the sum of all ownership interests in a company and claims on its assets from both debt and equity holders. Enterprise value represents the full cost of acquisition of a company, It can be used to value the obligations to settle or the costs to pay for a company who wants to takeover or acquire another. Enterprise value can be derived by summing up the equity value, total debt, preferred stock and non-controlling interests and then deducting cash and cash equivalents.
The main idea for deducting cash and cash equivalents is because cash and cash equivalents represent a bonus to the acquiring company. They do not serve as costs but rather as benefits to the acquiring company. In light of this, the overall impact of cash and cash equivalents would be to reduce the acquisition cost paid by the acquiring company.
Debt and preferred stock are added because on acquisition, the acquirer takes over both the assets and liabilities of the acquired company; it then has to settle these liabilities which include debts and minority interests.Minority interest (Non-controlling interests) represents the percentage of the company’s equity that is not owned by the parent company.
The formula for enterprise value is
Equity value + Total debt + Preferred stock + Non-controlling interests – Cash and Cash equivalents
A major positive thing about Enterprise value is that it is independent of capital structure. This means that the enterprise value remains unchanged even with a change in the capital structure. Take for example if a company raises additional debt held in the balance sheet as cash, its enterprise value remains constant as the new debt is offset by the increase in cash. Also if equity holding is reduced through share repurchases from available cash, the reduction in equity value is offset by a reduction in cash also.
Similarly, if a company issues equity and uses the proceeds to repay debt, the incremental equity value is offset by the decrease in debt.
Equity value is widely scrutinized by both potential and existing investors because it presents a snapshot of both current and potential future value. It is the value of a company available to owners or shareholders. Equity value accounts for all the ownership interest in a firm including stock options and convertible securities.
Equity value can be calculated in two ways, which are either the intrinsic value method or the fair value method.
Intrinsic value method
= Market Capitalization + Amount that in-the-money stock options are in the money + Value of equity issued from in-the-money convertible securities – proceeds from the conversion of convertible securities.
Fair Market Value (Equity Value)
=Market Capitalization + Fair value sum of all stock options in the money and out of the money + Value of convertible securities.
Equity Value Multiples
P/E ratio is a trading multiple investors mostly use to make decisions of whether to invest in a company or not. It measures how much investors are willing to pay for a company’s current or future earnings.
The formula is derived by
P/E avails the investor the opportunity to determine whether or not the current P/E ratio is a reasonable price to pay for a dollar worth of a company’s earnings.
Enterprise Value Multiples
- EV / EBITDA:
EBITDA means earnings before interest, tax, depreciation and amortization. It is independent of capital structure because it is income before paying any interest expense or taxes. Also amortizations such as acquisition- related amortization are excluded and added back as well as depreciation. In this regard, EBITDA is free from all sorts of distortions or manipulations.
EV/ EBITDA can be used to determine the fair market value of a company.
- EV / EBIT:
The EV/EBIT seeks to measure how expensive or cheap a company’s share is relative to competing firms. The main short coming of the EV/EBIT is that it is subject to distortions and may not fully bring out the profitability or fair market value of a business. This is because depreciation and amortizations are subtracted from earnings. One company may have spent heavily on equipment and machinery in recent years, thereby increasing depreciation and amortization for the current and future years, while another company may have deferred its capital spending until a future period. For the former, the resulting effect would be to increase the ratio, which means purchasing stock in the company is more expensive relative to competing firms or wider market.
- Enterprise Value to Sales Multiple:
Enterprise Value to sales multiple is also used as a valuation metric, it is believed that the lower the Ev/ Sales multiple, the more attractive and/or undervalued the company is. This is because the lower the ratio, the more sales covers the enterprise value. A company with annual sales
Sales represents size, it gives the value of total revenue coming into the business. it should be noted that it does not mean that the higher the sales, the more profitable the business is. Huge Sales do not necessarily translate into profitability of cash flow generations. This is because a company might make sales, but with an alarming Cost of Goods Sold (“COGS”), profits may not be substantial.
Also Sales may be made on credit especially if the value is large; and by so doing there is no cash inflow to the company.
The formula for Enterprise value to Sales Multiple is :
Michael C. Thomsett.,Getting Started in Stock Investing and Trading.