Wall Street Prep

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.

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.

Comments

43
Leave a Reply

avatar
newest oldest most voted
Michael
Michael

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 accurately described as EC?

Haseeb Chowdhry
Haseeb Chowdhry

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

Martinerock
Martinerock

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

Erniza
Erniza

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) from equity value and not enterprise value? Why? 2. Net debt includes besides borrowing and cash, dividend payable, invoices more than 6 months and provision for share option scheme. While I understand the reason to add debt in the computation of enterprise value as another funder, why the rest should… Read more »

Haseeb Chowdhry
Haseeb Chowdhry

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, so in essence, it's cash and other items that are being effectively, carved out of the remaining stake to be sold.

Let me know if you need further clarification on these points.

hang
hang

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?

Haseeb Chowdhry
Haseeb Chowdhry

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 could theoretically (using an acquisition as an example) buy a company and use its cash to help pay down its existing debt. In some cases you see the Equity value > EV because Net Debt is negative, indicating that it has more cash than debt. That is, once all the… Read more »

Hang
Hang

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 wacc). Technically we are calculating a firm's future cash flow to their equity holders and discounting it back to their present value. We do not include cash in the calculation. So may I know what is the definition of MEV in your opinion, and given 2 firms having the same… Read more »

Haseeb Chowdhry
Haseeb Chowdhry

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 the equity holders would have a claim on the remaining excess cash. So, with no debt, the equity holders would receive the discounted value of the future cash flows to equity holders plus the available cash on the balance sheet.

Thanks,
Haseeb

Hang
Hang

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 equity value will be 100 mil less than A, BUT their EV will be the same. Since firm B's EV will be fcfe/(cost of equity) less cash (cash=0).

I am assuming constant, similiar fcfe and cost of equity for both firm.

Many thanks,
Hang

Haseeb Chowdhry
Haseeb Chowdhry

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!

Hang
Hang

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 equity but one firm has an additional 100mil.

I am thinking if the adjustment should be made in the discount rate since the firm that has cash will be relatively 'safer' to invest in?

Many thanks,
Zheng Hang

Haseeb Chowdhry
Haseeb Chowdhry

Hang,

Yes - that makes sense - we cover this topic in the DCF course - in lesson 46.

Alex
Alex

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) – Cash and Short term investments ($15 million) = $35 million. While both companies have the same market capitalization and no debt, the better deal is Company B as you would assume $15 million in cash upon purchase of the company." Is Company B technically a better deal? It is cheaper… Read more »

Alex
Alex

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.

Haseeb Chowdhry
Haseeb Chowdhry

Alex,

When looking at houses, you typically don't look at Excess cash - so this analysis may not hold as much weight.

Haseeb Chowdhry
Haseeb Chowdhry

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.

Bob
Bob

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 divestiture (let's say $2 billion). Then when the divestiture is complete, the new company would have $8 bil in equity and either $0 bil in debt or $2 bil in debt. In this situation we could have the exact same company with either $8 bil in enterprise value or $10… Read more »

Haseeb Chowdhry
Haseeb Chowdhry

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 the lemonade stand example - if you had bought the lemonade stand with a 5-year note, the enterprise value of the business would be inclusive of the debt you took on to finance your asset.

Jon
Jon

Thanks for the article.

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

Shannan Wilson
Shannan Wilson

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 company has no debt), you would not deduct/add trade payables and receivables. Note, Enterprise Value does not equal the value of the whole business, but only the value of the core operations (operating assets - operating liabilities) whereas equity value measures the portion of the entire business that belongs to… Read more »

Haksh
Haksh

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 debt, company is doing it the other way around)? By deducting liabilities , that are actually adding trade payables and by adding cash , they are actually adding cash , trade recievables and investments
Is this a correct valuation method ?
Thank u

Shannan Wilson
Shannan Wilson

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 revenue), and the government (income taxes payable.) Financial liabilities include debt - any short term and/or long term interest-bearing liabilities and debt equivalents such as retirement liabilities (unfunded pension liabilities, unfunded post-retirement medical liabilities, etc.) and various reserves. Some off-balance sheet financing is also included in calculating debt in certain… Read more »

Amanda
Amanda

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

Haseeb Chowdhry
Haseeb Chowdhry

What you are suggesting is basically an incremental ROI calc: incremental return / incremental investment - 1

Jack
Jack

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 is $200k and the Debt is $500k. In this scenario, spending an additional $100,000 on improvements has created a profit of $100,000. My question is how do we measure the return? Surely Return on Equity is measured by Profit / Equity Value. In this scenario the Profit is $100,000 and… Read more »

Haseeb Chowdhry
Haseeb Chowdhry

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.

Amy
Amy

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

Haseeb Chowdhry
Haseeb Chowdhry

If cash > debt, you will have negative net debt, which will make enterprise value < equity value. Hope this helps!

Wael
Wael

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 that the company should have zero USD liabilities).On the same date the net equity in the financial position statement was -$20M. Can I say here that the market value of the company is $80M (100-20)?
Thank you

Haseeb Chowdhry
Haseeb Chowdhry

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.

Frank
Frank

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...

Shannan Wilson
Shannan Wilson

Hi Jon,
You would typically use the book value of debt.
Shannan

Gustavo
Gustavo

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.

Haseeb Chowdhry
Haseeb Chowdhry

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.

Gustavo
Gustavo

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?

Haseeb Chowdhry
Haseeb Chowdhry

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 Value

Equity Value + Net Debt = Enterprise Value

Equity Value + Debt - Cash = Enterprise Value

Hamdan
Hamdan

Simple and comprehensive. Thanks a lot for this!

richard chu
richard chu

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 🙂

Haseeb Chowdhry
Haseeb Chowdhry

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!

Melanie
Melanie

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

Haseeb Chowdhry
Haseeb Chowdhry

Thanks Melanie!

Mia
Mia

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

X

The Wall Street Prep Quicklesson Series

7 Free Financial Modeling Lessons

Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts.