Question on Enterprise Value

[RandomInvestor]

Hey so I reading something and I always see the word "value" get used. Value in the context of a business means what its worth. But one thing confuses me, when I go on enterprise value look at the definition it says "Enterprise Value, or EV for short, is a measure of a company's total value". So last part it says a company's total value, what its worth. Doesn't this have something to do with the intrinsic value of the company? the definition of enterprise value which is the measure of a company's value is same as intrinsic value which is what something is pretty much worth, in this case the company. What am I missing?

 

[Cam019]

Enterprise value can be thought of as the takeover cost to acquire a whole business when you take into account market capitalisation plus company debt, minority interests, and preferred shares minus cash and cash equivalents. Enterprise value is not intrinsic value. Intrinsic value is an investors interpretation of a businesses true value and will differ between investors calculating it.

 

[RandomInvestor]

Enterprise value can be thought of as the takeover cost to acquire a whole business when you take into account market capitalisation plus company debt, minority interests, and preferred shares minus cash and cash equivalents. Enterprise value is not intrinsic value. Intrinsic value is an investors interpretation of a businesses true value and will differ between investors calculating it.

The intrinsic value part makes sense but still confused on the EV. I think though what it means is all these things combined is when the company is worth at market value, is this correct?

 

[ReXXar]

The intrinsic value part makes sense but still confused on the EV. I think though what it means is all these things combined is when the company is worth at market value, is this correct?

There's different ways to calculate EV. I have my own way where I add negative working capital and off-balance sheet liabilities. So if you understand the formula of whatever EV you're looking at, then you would've answered your own question.

 

[RandomInvestor]

There's different ways to calculate EV. I have my own way where I add negative working capital and off-balance sheet liabilities. So if you understand the formula of whatever EV you're looking at, then you would've answered your own question.

It didn't answer it unfortunately. This is what the formula says:

EV = market value of common stock + market value of preferred equity + market value of debt + minority interest - cash and investments.

But is my description above correct?

 

[skc]

The intrinsic value part makes sense but still confused on the EV. I think though what it means is all these things combined is when the company is worth at market value, is this correct?

Just take a simple company with nothing but a single piece of asset.... let's say $10m in bond investments.

For one reason or another, this company has a market cap of $5m.

The company also has debt of $6m, the debt has a fair market value at par.

So...
- the market value of the company is $5m, being the observed market cap of the company.
- the enterprise value of the company is $11m, being the market cap plus the value of the debt. If I want to buy this company free of debt, $11m is what I need to pay.
- the intrinsic value of the company is subjected to anyone's interpretation. Investor A might say it's $4m, being $10m of bonds less $6m debt. Investor B might say it's $2m, because the company will incur ongoing costs whilst doing nothing with its assets. Investor C might say it's $15m because the management are awesome and are about to make great returns from the company's assets.

 

[RandomInvestor]

Just take a simple company with nothing but a single piece of asset.... let's say $10m in bond investments.

For one reason or another, this company has a market cap of $5m.

The company also has debt of $6m, the debt has a fair market value at par.

So...
- the market value of the company is $5m, being the observed market cap of the company.
- the enterprise value of the company is $11m, being the market cap plus the value of the debt. If I want to buy this company free of debt, $11m is what I need to pay.
- the intrinsic value of the company is subjected to anyone's interpretation. Investor A might say it's $4m, being $10m of bonds less $6m debt. Investor B might say it's $2m, because the company will incur ongoing costs whilst doing nothing with its assets. Investor C might say it's $15m because the management are awesome and are about to make great returns from the company's assets.

Ah ok that makes sense, one more thing what do you mean when you say fair market value "at par"?

 

[skc]

Ah ok that makes sense, one more thing what do you mean when you say fair market value "at par"?

All debt has a face value and when the market value = face value it's called at par.

Market value of debt can change depending on a host of factors... like structure of bond, prevailing interest rate, credit worthiness of the issuer etc. For example, Slater and Gordon debt were sold at 25% of par by the bank lenders to the hedge funds.

It's not important to this example other than to say that the debt are worth exactly as stated on the balance sheet.

 

[Value Hunter]

O.P. you have received the explanation of what enterprise value is and how it is calculated I will now explain a little about why it is used.

The concept of enterprise value stems from the idea what if I theoretically wanted to buy 100% of the equity and buy/pay off the debt instruments of the company. In other words what would it cost for to purchase "full control" of the company's assets (because debt has covenants and can restrict the control that shareholders have over the company).

Enterprise value is often used as an analysis tool in takeovers because the acquirer gets full control of the balance sheet and can thus influence the amount of debt (and debt like instruments) and equity on the balance sheet.

Takeovers are sometimes priced on an Enterprise value to EBIT or enterprise value to EBITDA multiple. EBIT is earnings before interest and tax and EBITDA is earnings before interest tax, depreciation and amortization. The reason being if they change the amount of the debt on the balance sheet post acquisition that changes the amount of interest and tax paid (interest is usually tax deductible) hence they want to see the valuation before the impact of changing the balance sheet as an analytical tool.

Furthermore EBIT is often used in takeovers because often bank covenants in regards to interest coverage (and hence the amount of debt financing they can obtain to make the takeover) revolve around EBIT with interest cover typically defined as EBIT/interest costs. Interest cover is calculated that way because as mentioned previously interest costs are usually tax deductible. Many takeovers are partially financed by debt (and in the case of many private equity deals majority financed by debt).

As for EBITDA the theory is that if for example you are a private equity firm buying certain long life assets and flipping them within as short time frame the depreciation and amortization do not represent real costs to you. Amortization because its not a "cash cost" and is usually just writing off of good will and depreciation because you can potentially get away with spending less and sometimes almost nothing (as private equity often does) on capital expenditure (i.e. replacing/maintaining assets) for the business if you are flipping the business quickly (for example putting the company up for IPO in 3 years time). Hence in some cases where capital expenditures can largely be delayed until after the business is on sold/flipped then EBITDA is a more relevant measure of debt servicing ability than EBIT.

Personally I do not like to use Enterprise value because I am not buying the whole company and have no control over the balance sheet/debt financing. Because I only own the equity as a minority common shareholder, metrics like EBIT are not as relevant to me (although still relevant for calculating interest cover, takeover potential, etc) because Net profit after tax which is what shareholders get is after the interest and tax are paid. If you also own the debt EBIT is more relevant to you.

 

[skc]

O.P. you have received the explanation of what enterprise value is and how it is calculated I will now explain a little about why it is used.

In addition to everything you've said... it's also used for comparison purpose. So say 2 companies hold the exact same asset (say 50% share in a Joint Venture), yet company A has a market value of $40m and company B has a market value of $100m. A quick look at the balance sheet you will find that's because Company A also has $60m in debt while company B is debt free. So they have equivalent Enterprise value.

It's useful for valuation across peers who have different balance sheet structures.

 

[RandomInvestor]

All debt has a face value and when the market value = face value it's called at par.

Market value of debt can change depending on a host of factors... like structure of bond, prevailing interest rate, credit worthiness of the issuer etc. For example, Slater and Gordon debt were sold at 25% of par by the bank lenders to the hedge funds.

It's not important to this example other than to say that the debt are worth exactly as stated on the balance sheet.

Ah ok thanks.

 

[RandomInvestor]

O.P. you have received the explanation of what enterprise value is and how it is calculated I will now explain a little about why it is used.

The concept of enterprise value stems from the idea what if I theoretically wanted to buy 100% of the equity and buy/pay off the debt instruments of the company. In other words what would it cost for to purchase "full control" of the company's assets (because debt has covenants and can restrict the control that shareholders have over the company).

Enterprise value is often used as an analysis tool in takeovers because the acquirer gets full control of the balance sheet and can thus influence the amount of debt (and debt like instruments) and equity on the balance sheet.

Takeovers are sometimes priced on an Enterprise value to EBIT or enterprise value to EBITDA multiple. EBIT is earnings before interest and tax and EBITDA is earnings before interest tax, depreciation and amortization. The reason being if they change the amount of the debt on the balance sheet post acquisition that changes the amount of interest and tax paid (interest is usually tax deductible) hence they want to see the valuation before the impact of changing the balance sheet as an analytical tool.

Furthermore EBIT is often used in takeovers because often bank covenants in regards to interest coverage (and hence the amount of debt financing they can obtain to make the takeover) revolve around EBIT with interest cover typically defined as EBIT/interest costs. Interest cover is calculated that way because as mentioned previously interest costs are usually tax deductible. Many takeovers are partially financed by debt (and in the case of many private equity deals majority financed by debt).

As for EBITDA the theory is that if for example you are a private equity firm buying certain long life assets and flipping them within as short time frame the depreciation and amortization do not represent real costs to you. Amortization because its not a "cash cost" and is usually just writing off of good will and depreciation because you can potentially get away with spending less and sometimes almost nothing (as private equity often does) on capital expenditure (i.e. replacing/maintaining assets) for the business if you are flipping the business quickly (for example putting the company up for IPO in 3 years time). Hence in some cases where capital expenditures can largely be delayed until after the business is on sold/flipped then EBITDA is a more relevant measure of debt servicing ability than EBIT.

Personally I do not like to use Enterprise value because I am not buying the whole company and have no control over the balance sheet/debt financing. Because I only own the equity as a minority common shareholder, metrics like EBIT are not as relevant to me (although still relevant for calculating interest cover, takeover potential, etc) because Net profit after tax which is what shareholders get is after the interest and tax are paid. If you also own the debt EBIT is more relevant to you.

Ah ok bit confusing but I'll re-read it couple times. Thanks.

 

[Primate]

Most people have said it well above. My take is that it is the value of the business (Enterprise) independent of how it is financed. The operations of a company are financed by a mix of debt and equity. Imagine 2 identical companies, both of which have invested $10M in plant and equipment. At that point, the enterprise value of each company is $10M.
Company A used no debt, it only sold equity (shares) to raise the $10M. It's market capitalisation, or equity value, is the same as the enterprise value in this case (number of shares times the value of each share.)
Company B paid for its plant and equipment using $8M of debt, and only sold $2M of shares. It's market capitalisation is therefore only $2M, but the value of the company's assets is still $10M.

If you were to start an identical business, you would need to spend $10M regardless of how you financed it, therefore the Enterprise value is the equity value (market cap) plus the value of the debt. The last part of the equation is subtracting the cash & equivalents, because (aside from a small amount of working capital) These are not actually part of the business. (If I were to buy your house, I would not include the value of your furniture in determining what I should pay)