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.
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.
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.
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).