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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 definition

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.

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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.

Home improvement

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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Michael
Michael
April 28, 2018 11:07 pm

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 »

Bradley
Bradley
October 12, 2020 3:42 am

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?

Louis Liu
Louis Liu
October 9, 2020 5:19 pm

what if the company has minority interest?

Isaac Míguez
Isaac Míguez
May 7, 2020 6:55 am

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 »

Tatiana
Tatiana
April 2, 2020 12:11 am

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 »

Wojtek
Wojtek
February 21, 2020 3:55 pm

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 »

Uday Khanna
Uday Khanna
June 6, 2019 11:40 pm

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 »

Dhanesh Kumar
Dhanesh Kumar
January 16, 2019 3:20 am

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 »

Simon
Simon
January 6, 2019 9:01 am

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?

Martinerock
Martinerock
April 28, 2018 12:59 am

Hellow my name is Martinerock. Wery proper post! Thx 🙂

Erniza
Erniza
November 29, 2017 5:20 am

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 »

hang
hang
September 6, 2017 10:13 pm

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?

Alex
Alex
April 17, 2017 9:58 pm

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 »

Alex
Alex
April 17, 2017 7:34 pm

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.

Bob
Bob
February 6, 2017 2:10 pm

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 »

Jon
Jon
August 9, 2016 1:00 am

Thanks for the article.

When deriving Equity Value from Enterprise Value, should the book value or target value of debt be used?

Haksh
Haksh
May 16, 2016 2:55 pm

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 »

Amanda
Amanda
April 26, 2016 5:29 pm

When referring to net debt, do you just mean bank debt or referring to other LT liabilities?

Jack
Jack
December 16, 2015 8:10 am

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
Amy
November 12, 2015 1:30 am

How would you calculate the implied ev for an aquistion with the buyer ev and ebidta and target ebidta given?

Wael
Wael
September 13, 2015 9:49 pm

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 »

Gustavo
Gustavo
July 13, 2015 9:25 am

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.

Hamdan
Hamdan
March 29, 2015 4:09 am

Simple and comprehensive. Thanks a lot for this!

richard chu
richard chu
February 3, 2015 2:59 am

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 🙂

Melanie
Melanie
January 18, 2015 1:04 pm

Fabulous way to vulgarize financial concepts by putting them into every day examples that are intuitive and easy to understand. Merci.

Mia
Mia
January 8, 2015 4:54 pm

Thank you for a very good article! It really helped me to understand what equity and enterprise value actually are.

X

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