Enterprise Value vs Equity Value
Understanding the difference between the two perspectives of value ensures that free cash flows and discount rates are calculated consistently
Enterprise value is often misunderstood
Questions surrounding enterprise value vs equity value seem to pop up again and again 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 those concepts.
There is of course a good reason for this: Many newly hired analysts lack training in "real world" finance and accounting. They're hired, they're put through an intense "drinking through firehose" training program, and 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.
A common enterprise value question
I have often been asked the following question (in various permutations):
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?
The short answer is that it doesn't make sense, because the premise is wrong. Adding debt will not raise enterprise value. Read below for the long answer.
Enterprise value definition
Enterprise value equals equity value plus net debt (where net debt is defined as debt and equivalents minus cash).
Enterprise value (EV) = Equity value (QV) + Net debt (ND)
Enterprise value example
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 out new analyst’s question. Does adding debt and subtracting cash increase a company’s value? Let’s see: 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.
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.
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.
$100,000 in improvements increase 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.
$100,000 in improvements raise value of 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.
$100,000 in improvements raise value of house by $50k
EV ($550,000) = QV ($50,000) + ND ($400,000 + $100,000)
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.
This comes into play in comparables modeling as well – bankers analyze both enterprise value multiples (i.e. EV/EBITDA) and equity value multiples (i.e. P/E) to arrive at valuation. Understanding the difference between the two perspectives of value is crucial here as well and will prevent inconsistent analysis.
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