Enterprise Value and Equity Value are two terms that have confused investors and sometimes professionals alike through the years. In this post, I shall try to clear some air on both the terms and help our readers figure out the one they need to use during their analysis of companies.
On a broad level, this will be long, but an easy read and we would really appreciate it if our readers leave comments in case of any doubts.
1. Who are the different stakeholders in a firm?
To understand the concept of Enterprise Value and Equity Value, it would first be necessary to understand the different players in the capital markets and their claims on a company’s capital and income.
To understand this, picture a company like a big country with different religious and social groups with each group seeking to pursue their own interest but somehow still managing to operate under the common banner of a company.
These interest groups from the perspective of a company include those who have contributed capital to the firm. Since a company can generate capital from debt and equity the top-level classification of the mentioned interest groups comprises of Debt Holders and Equity Holders
Note that the two groups can be further divided into subgroups depending on the priorities of each subgroup.
2. What is the level of risk and return associated with the level of ownership?
Incorporate finance, when an asset is sold the debt holders get a priority to the funds generated from the sale and then the different classes of equity holders.
Since debt holders normally take fixed payments at the regular periods regardless of the profit-generating capacity of a company, their position tends to be the one of minimum risk in the company’s capital structure.
The equity holders, on the other hand, get dividends only when the company makes a profit (in most cases) and also happen to pledge their money as owners of the firm without the promise of returns. This makes their position the riskiest within the capital structure.
The below infographic should summarise the relationship between capital and relevant risk and payments for different equity and debt holders.
3. What is Enterprise Value and Equity Value and how are they calculated?
Now to address the crux of this post, assume that a big financial investor wants to buy a company. Let us say he wants to get 100% control of the firm and also 100% of the earnings generated by the firm.
To achieve the first goal, he would just have to buy the stakes of equity holders of the firm, these equity holders could include the Minority Interest, the Preferred Shareholders, and the Common Shareholders. The money the buyer would have to expend to acquire the complete equity of all the above-mentioned groups is what is known as the Equity Value.
Now since the equity holders are of the picture, the buyer now turns his eyes towards the debt holders. To make the debt holders give up claims to the company’s earnings (in the form of interest and principal payments), our buyer would have to pay them cash equivalent to the debt they hold in the company. A lot of the times, the buyers use the cash and cash equivalents of the company they bought to pay off the debt outstanding on the balance sheet. In finance, the term used for the is called the Net Debt.
Net Debt = Total Debt – Cash and Cash Equivalents
And further, the formula for Enterprise value becomes
Enterprise value = Equity Value + Net Debt
Assuming the company has also got minority interest, preferred shareholders and affiliates/associates the formula gets modified as
Enterprise Value = Equity Value + Preferred Shares + Minority Interests – Value of Associates + Net debt
4. What are the Enterprise Value and Equity Value multiples?
The key difference between Enterprise Value and Equity Value is the inclusion of the Net Debt figure in the calculation. So when we think of multiples only terms that have the payments related to debt (interest) should be included with Enterprise Value and the metrics devoid of debt payments (interest) should be included with Equity Value.
The following figure should give the summary of the financial statement components used with both Enterprise Value and Equity Value.
As mentioned earlier, please note in the income statement that all metrics which include interest is included with the Enterprise Value calculation.
The corresponding ratios are summarised in the following figure
5. Methods of analysis using Enterprise Value and Equity Value
The multiples of Enterprise Value and Equity Value can be used extensively in the valuation analysis of a company. The two methods of valuation that are commonly used are relative valuation and historical valuation.
The limitation of using the relative valuation method is that during the period of elevated valuations- during a bull market all our comparable companies may be trading at a premium, this may sometimes make our target company seem cheap when it is only less expensive.
Similarly, during periods of depressed valuations, our target company may look expensive compared to our comparables when it is actually only slightly less cheap.
6. Closing thoughts
Although a lot of retail investors do not use Enterprise Value multiples in their valuations to could be useful to do so since the resulting valuations are inclusive of the leverage the companies have employed in their business activities.
In case retail investors find the concept of Enterprise value confusing, it should not deter them from performing a good analysis of companies if they use other leverage evaluation methods in their research and analysis process.
We hope our readers continue to embrace an objective approach to their valuation processes while performing stringent quality checks on the stocks they invest in. Happy Investing.