What is Enterprise Value vs. Equity Value?
Enterprise Value vs. Equity Value is an often-misunderstood topic, even by newly hired investment bankers. Understanding the distinction ensures that the free cash flows (FCF) and discount rates are consistent and that valuation models are built correctly.
Table of Contents
Enterprise Value Definition
Questions surrounding enterprise value vs equity value seem to pop up frequently in our corporate training seminars. In general, investment bankers seem to know a lot less about valuation concepts than you’d expect given how much time they spend building models and pitchbooks that rely on these concepts.
There is, of course, a good reason for this: Many newly hired analysts lack training in “real world” finance and accounting.
New hires are put through an intense “drinking through firehose” training program, and then they’re thrown into the action.
Previously, I wrote about misunderstandings surrounding valuation multiples. In this article, I’d like to tackle another seemingly simple calculation that is often misunderstood: Enterprise value.
Learn More → Enterprise Value Quick Primer
Enterprise Value Interview Question
Enterprise Value (EV) Formula
I have often been asked the following question (in various permutations):
Enterprise Value (EV) = Equity Value (QV) + Net Debt (ND)
If that’s the case, doesn’t adding debt and subtracting cash increase a company’s enterprise value?
How does that make any sense?
The short answer is that it doesn’t make sense, because the premise is wrong.
In fact, adding debt will NOT raise enterprise value.
Why? Enterprise value equals equity value plus net debt, where net debt is defined as debt and equivalents minus cash.
Enterprise Value Home Purchase Value Scenario
An easy way to think about the difference between enterprise value and equity value is by considering the value of a house:
Imagine you decide to buy a house for $500,000.
- To finance the purchase, you make a down payment of $100,000 and borrow the remaining $400,000 from a lender.
- The value of the entire house – $500,000 – represents the enterprise value, while the value of your equity in the house – $100,000 – represents the equity value.
- Another way to think about it is to recognize that the enterprise value represents the value for all contributors of capital – for both you (equity holder) and the lender (debt holder).
- On the other hand, the equity value represents only the value to the contributors of equity into the business.
- Plugging these data points into our enterprise value formula, we get:
EV ($500,000) = QV ($100,000) + ND ($400,000)
So back to our new analyst’s question. “Does adding debt and subtracting cash increase a company’s value?”
Imagine we borrowed an additional $100,000 from a lender. We now have an additional $100,000 in cash and $100,000 in debt.
Does that change the value of our house (our enterprise value)? Clearly not – the additional borrowing put additional cash in our bank account, but had no impact on the value of our house.
Suppose I borrow an additional $100,000.
EV ($500,000) = QV ($100,000) + ND ($400,000 + $100,000 – $100,000)
At this point, a particularly clever analyst may answer, “that’s great, but what if you used that extra cash to make improvements in the house, like buying a subzero fridge and adding a jacuzzi? Doesn’t net debt go up?” The answer is that in this case, net debt does increase. But the more interesting question is how the additional $100,000 in improvements affects enterprise value and equity value.
Home Improvement Scenario
Let’s imagine that by making $100,000 of improvements, you have increased the value of your house by exactly $100,000.
In this case, enterprise value increased by $100,000 and equity value stays unchanged.
In other words, should you decide to sell the house after making the improvements, you’ll receive $600,000, and have to repay the lenders $500,000 and pocket your equity value of $100,000.
The $100,000 in improvements increases the value of the house by $100,000.
EV ($600,000) = QV ($100,000) + ND ($400,000 + $100,000)
Understand that the enterprise value didn’t have to increase by exactly the amount of money spent on the improvements.
Since the enterprise value of the house is a function of future cash flows, if the investments are expected to generate a very high return, the increased value of the home may be even higher than the $100,000 investment: Let’s say the $100,000 in improvements actually increase the value of the house from $500,000 to $650,000, once your repay the lenders, you’ll pocket $150,000.
The $100,000 in improvements raises the value of the house by $150k.
EV ($650,000) = QV ($150,000) + ND ($400,000 + $100,000)
Conversely, had your improvements only increased the value of the house by $50,000, once you repay the lenders, you’ll pocket only $50,000.
EV ($550,000) = QV ($50,000) + ND ($400,000 + $100,000)
The $100,000 in improvements, in this case, raised the value of the house by $50k.
Why Enterprise Value Matters?
When bankers build a discounted cash flow (DCF) model, they can either value the enterprise by projecting free cash flows to the firm and discounting them by a weighted average cost of capital (WACC), or they can directly value the equity by projecting free cash flows to equity holders and discounting these by the cost of equity.
Understanding the difference between the two perspectives of value ensures that free cash flows and discount rates are calculated consistently (and will prevent the creation of an inconsistent analysis).
This comes into play in comparables modeling as well – bankers can analyze both enterprise value multiples (i.e. EV/EBITDA) and equity value multiples (i.e. P/E) to arrive at a valuation.
I struggle with the notion that a business which may have cost £1m of equity + £3m of debt to establish could have an enterprise VALUE of £4m as, if it doesn’t produce a profit, clearly no one would pay what it COST to set up. Isn’t EV therefore more… Read more »
Michael,
Pardon my ignorance here, but when you are referring to the acronym EC, what is the full term? Thanks – I should be able to clarify more afterwards!
– Haseeb
He probably means Enterprise Cost as he alluded to in his statement that he believes it is more a descriptor of the initial cost to setup the company.
Umair: Thanks for the color. I’m still not sure what the question is. Early on in our simple example then enterprise value does equal cost. However if the business is earning a return on capital greater than its cost of capital then enterprise value should be higher than its initial… Read more »
The key assumption you’re missing here is that it is MARKET value of equity and debt not the initial capital contributed. A company with zero profit (assuming it would not produce profit in the future years either and pays off interest) would have zero equity value. Assuming market value of… Read more »
Hi, Adil, You are correct that the market value of equity and debt (less cash), not the book value (or initial cost) are a better indicator of the enterprise value. However, in the case you describe, the equity book value would still include both the original contributed capital ($1mm) and… Read more »
Hellow my name is Martinerock. Wery proper post! Thx 🙂
Hello, one of the conclusions inferred from modigliani and miller is that a firm´s value is increased simply by using financial leverage due to the tax benefits caused by deductibility of interest expense as long as financial leverage is not used to the point of increasing bankruptcy risk and therefore… Read more »
Isaac:
I believe corporate finance books do make this point, hence your reference to Modigliani-Miller.
Best,
Jeff
Enterprise value = equity value + net debt. If that’s the case, doesn’t adding debt and subtracting cash increase a company’s enterprise value. How does that make any sense? Can this mean holding cash is unproductive? Does debt mean active investing? Perhaps rearranging the equation makes more sense: Enterprise value… Read more »
Shivram:
Enterprise value doesn’t change because simply adding debt increases cash so the two offset each other. But yes, holding a lot of cash is unproductive as it is a wasting asset.
Best,
Jeff
If a company has a $200 equity value and takes on 200 dollars in debt, and then recieves the 200 in cash, enterprise value is 200+(200debt)-200cash. so enterprise value is 200. Suppose the company spends 180 dollars and value of business doesnt change. SO now the equity value of business… Read more »
Uday: Because it invested $180 in an operating asset that would presumably generate future free cash flows. Putting aside the traditional enterprise value equation, EV is the value of operations, so the market value of all operating assets less the market value of all operating liabilities. It’s similar to the… Read more »
Most definitions of EV is: TEV is the value of core operations LESS non-operating. I’m a bit confused, as Koller et al (Valuation 7 ed.), by many considered as the “bible” on the topic defines EV as: TEV is the value of core operations (derived via DCF of FCFF) PLUS… Read more »
Erik:
Yes, there are slightly different interpretations. However, the most common interpretation is what we discuss and cover versus McKinsey’s definition.
Best,
Jeff
Hi, for firm valuation- if I use unlevered cash flows and discount them back do i automatically get enterprise value? or do i need to add the debt of the company?
Anna:
You would obtain enterprise value if you discount unlevered free cash flows back to the present at the WACC.
Best,
Jeff
2 questions:
1. When would EV be lower than equity value? I believe this has something to do with EV being the value of operating assets vs eqv being the value of non-operating assets
2. If I pay off all my debt today next day, will EV change overnight?
Bradley: 1. When non-operating assets like cash are greater than debt (see Apple as an example). 2. In theory, no, assuming you use all of your existing cash to pay off the debt. However, in reality, the company’s equity value may change due to a change in the cost of… Read more »
what if the company has minority interest?
Louis:
It is considered a debt equivalent.
Best,
Jeff
Hello! Great article! thank you! I would like to get your opinion on the valuation of the expansion with new debt and equity. In the DCF where future cash flows have expansion considered but debt has not been drawn yet, do I need to account for this new debt to… Read more »
Tatiana:
With a changing capital structure/future issuances, we recommend the Adjusted Present Value approach. There are many resources to learn more, especially Aswath Damodaran’s website.
Best,
Jeff
Hi. Should I subtract existing debt and add existing cash to the model? I always thought, that the FCFF = FCFE + FCFD, so when using FCFF model and coming with the EV, shouldn’t I use forecasted present value of future FCFD, rather than using the Net Debt as of… Read more »
Wojtek: I’m not sure I’ve ever seen FCFD before but it seems very similar to our leveraged FCF calculation (that we don’t really spend much time). Keep in mind, when valuing a company you are valuing it based on today’s pricing and today’s capital structure (while using future cash flows).… Read more »
Hello, The article makes clear that enterprise value represents the value for all contributors of capital – i.e equity holder and the lender (debt holder). In light of this, kindly resolve my following two queries. Query 1: Since liabilities include financial and operating liabilities. If the Enterprise value of my… Read more »
Dhanesh: 1. Option 2 is the correct answer (Equity Value of $600). Enterprise value is the value of operations; to arrive at equity value we deduct financial liabilities like loans and debt and add-back cash. Accounts payable is already implicitly included in your given enterprise value of $1000. 2. Deferred… Read more »
EV ($600,000) = QV ($100,000) + ND ($400,000 + $100,000) … at this point, selling the house at $600,000 has no profit, right? because the amount $100,000 is same as initial cash down payment… is it correct?
Yes, at this point, there is no profit – thanks!
Hi, I need your comment on a valuation calculation for a disposal of a stake in a subsidiary. The disposal price computation uses equity value deriving from enterprise value (EBITDA multiple) less net debt. My question : 1. Is it correct to calculate the valuation of a stake (disposal price)… Read more »
Erniza, Good questions – see my responses below. 1. Yes – since the equity is being sold, and the associated debt on the business would be assumed by the purchasing entity. 2. The other items look like cash that has already been earmarked to be paid out/distributed to certain parties,… Read more »
Given 2 houses having similar FCFE moving forward, one have a million dollar inside the house when the other dont. In terms of equity and enterprise value, what will they be like?
Hi Hang, Remember that EV is an intrinsic value of the company’s operations. Cash is a “non – operational” asset. In this particular case, it depends. With regards to EV, remember that it is the MV of the Equity + Net Debt. Net Debt = Debt – Cash because you… Read more »
Hi Haseeb, Thank you for your reply. I got the idea coverting from EV to equity value. However, my question is something else. Lets think about it from their formula perspective, given that you use fcfe to forcast, and discount it using a capm model (cost of equity instead of… Read more »
Hi Hang, When comparing the intrinsic market value of equity between 2 firms (one with 0 debt and 1 with cash) – the one with cash will have a higher value because after the debt holders have been paid off with the cash on the balance sheet (net debt), then… Read more »
Hi Haseeb, Just for confirmation, so in this case, a debt free, with 100mil cash, firm A’s equity value will be fcfe/(cost of equity) plus cash, then it’s EV will be fcfe/(cost of equity) in this case (which is equity value less cash)? Similiarly, the cashless, debt free, firm B’s… Read more »
Hang,
You are correct on both counts –
Firm A: Derived equity value assumes cash is already part of equity value, and you could deduct cash from equity to get to enterprise value
Firm B: Since net debt = 0, equity value = enterprise value
Hope this helps!
Hi hasseb, Sorry for the late reply as i was travelling. Im glad that we are alike in thinking. But his brings me to the next question, how is cash accounted for in the calculation of fcfe/cost of equity? For example, both debt free firms has the same fcfe/cost of… Read more »
Hang,
Yes – that makes sense – we cover this topic in the DCF course – in lesson 46.
For the example in the article (copied below) “Calculate Enterprise Value for Scenario 2. EV for Company A is Market Capitalization ($50 million) + Debt ($0) – Cash and Short term investments ($5 million) = $45 million. EV for Company B is Market Capitalization ($50 million) + Debt ($0) –… Read more »
Can you explain through your example where…
House A
$100 equity value, $0 net debt
House B
$100 equity value, $10 excess cash
Thanks in advance.
Alex,
When looking at houses, you typically don’t look at Excess cash – so this analysis may not hold as much weight.
Alex,
While company B may be “cheaper”, a better way to look at these candidates would be to look at profitability numbers (i.e. EBIT, EBITDA), and in turn, multiples. The company that has a lower EV / EBITDA multiple may be the truly more cheap company.
Hi, this makes sense to me but I’m having difficulty in understanding enterprise value when a divesititure occurs. Let’s say a company divests / spins-off a subsidiary that would have a market cap of $8 billion. The company also decide arbitrarily to add some debt to the subsidiary before the… Read more »
Bob – I think the only missing piece here is that you can’t just “add debt” to the divesting business. If there is debt that has financed the assets that you are divesting, then it will be part of the enterprise value – hope this makes sense. Just think about… Read more »
Thanks for the article.
When deriving Equity Value from Enterprise Value, should the book value or target value of debt be used?
Haksh, Yes, you can directly value the equity by projecting free cash flows to equity holders and discounting these by the cost of equity. From here to obtain the enterprise value you would add net debt (which if there was any cash balance would be less than zero given the… Read more »
Hi, I need help with the following scenario : Could a fully equity financed company , use the discounted free cash flow technique, value it’s fair value of equity and add cash net of liabilities in order to arrive at the enterprise value ( although actual enterprise value states net… Read more »
Hi Amanda, Typically you can think of liabilities in two buckets – operating liabilities and financial liabilities. Operating liabilities result from the primary business operations of a firm. They are typically non-interest bearing; the most common operating liabilities are those related to suppliers (accounts payable), employees (accrued salaries), customers (deferred… Read more »
When referring to net debt, do you just mean bank debt or referring to other LT liabilities?
What you are suggesting is basically an incremental ROI calc: incremental return / incremental investment – 1
Great Article – very well explained. One question. Let’s take this example one step further. Let’s say the homeowner borrows an additional $100,000 to make improvements and as a result of these improvements the value of the house increases to $700,000. Therefore the Enterprise Value is $700k, the Equity Value… Read more »
Amy,
You are looking to buy the target out, correct? So if you have the target EBITDA, try to find comps to estimate an adequate EV / EBITDA multiple for the acquisition and apply that multiple to EBITDA to get to an implied enterprise value for the transaction.
How would you calculate the implied ev for an aquistion with the buyer ev and ebidta and target ebidta given?
If cash > debt, you will have negative net debt, which will make enterprise value < equity value. Hope this helps!
Thank you very much for this article. Actually I have a question and I hope to have an answer: At the same date (let us say 31/12/2014) a company was valuated for $100M free of debts (The potential acquirer is offering to pay $100M but on one condition which is… Read more »
Wael,
Enterprise Value = Equity Value + Net Debt. You are saying the equity is worth -20, correct? By definition the calculation would mean that the debt is $120 if you are offering $100 to buy it.
Why is this ? if you said EV = Equity value + net debt
Ev = (-20) + 100m
= 80
How do you get 120? Having a hard time understanding this…
Hi Jon,
You would typically use the book value of debt.
Shannan
Dear Matan,
What is your opinion when don’t have debt.
Example:
$100.000 cash
$500.000 house
If we follow de method is:
QV: 500.000 and EV = 500.000 + (0 – 100.000) -> 400.000.
Thank You,
Gustavo C.
Equity value is going to be defined as:
Enterprise Value – Debt + Cash => 600,000
In your equation above, equity value should be 600,000, which would give you an enterprise value of 500,000.
Hi Haseeb,
Thank you for reply. I agree with you. So sorry for my mistake.
But, how explain the value of equity is more than enterprise value in this case?
When a company has more cash than debt, that results in negative net debt, which means that equity value will be greater than enterprise value. Enterprise Value – Net Debt = Equity Value Enterprise Value – (Debt – Cash) = Equity Value Enterprise Value – Debt + Cash = Equity… Read more »
Simple and comprehensive. Thanks a lot for this!
wonderful article, cant be more clear.
one typo i noticed
Conversely, had your improvements only INCREASED the value of the house by $50,000, once you repay the lenders, you’ll pocket only $50,000.
should be decrease instead of increase 🙂
Richard – I would read it again – we’re saying that the value of the house only increased by $50k to $550k…it shouldn’t say decrease – thanks!
Fabulous way to vulgarize financial concepts by putting them into every day examples that are intuitive and easy to understand. Merci.
Thanks Melanie!
Thank you for a very good article! It really helped me to understand what equity and enterprise value actually are.