Enterprise value

Enterprise value (EV), Total enterprise value (TEV), or Firm value (FV) is an economic measure reflecting the market value of a whole business. It is a sum of claims of all claimants: creditors (secured and unsecured) and equityholders (preferred and common). Enterprise value is one of the fundamental metrics used in business valuation, financial modeling, accounting, portfolio analysis, etc.

EV is more comprehensive than market capitalization (market cap), which only includes common equity.

EV equation

Enterprise value =

common equity at market value (this line item is also known as "market cap")

+ preferred equity at market value

+ minority interest at market value, if any

+ debt at nominal value

+ unfunded pension liabilities and other debt-deemed provisions

- associate company at market value, if any

- cash and cash-equivalents including notes recievable and long term investments.

Comments on basic EV equation

• All the components particularly relevant in liquidation analysis, since using absolute priority in a bankruptcy all securities senior to the equity have par claims. Generally, also, debt is less liquid than equity so that the "market price" may be significantly different from the price at which an entire debt issue could be purchased in the market. In valuing equities, this approach is more conservative.
• Cash is subtracted because when it is paid out as a dividend after purchase, it reduces the net cost to a potential purchaser. Therefore, the business would cost that much less to start with. The same effect is accomplished when the cash is used to pay down debt.
• Value of minority interest is added because it reflects the claim on assets consolidated into the firm in question.
• Value of associate companies is subtracted because it reflects the claim on assets consolidated into other firms.
• EV should also include such special components as unfunded pension liabilities, employee stock option, environmental provisions, abandonment provisions, and so on, for they also reflect claims on the company's assets.
• EV can be negative in certain cases—for example, when there is more cash in the company than the value of the other components of EV.

Intuitive Understanding of Enterprise Value

• A simplified way to understand the EV concept is to envision purchasing an entire business. If you settle with all the security holders, you pay EV.

Usage

• Because EV is a capital structure-neutral metric, it is useful when comparing companies with diverse capital structures. Price/earnings ratios, for example, will be significantly more volatile in companies that are highly leveraged.

• Stock market investors use EV/EBITDA to compare returns between equivalent companies on a risk-adjusted basis. They can then superimpose their own choice of debt levels. In practice, equity investors may have difficulty accurately assessing EV if they do not have access to the market quotations of the company debt. It is not sufficient to substitute the book value of the debt because a) the market interest rates may have changed, and b) the market's perception of the risk of the loan may have changed since the debt was issued. Remember, the point of EV is to neutralize the different risks, and costs of different capital structures.

• Buyers of controlling interests in a business use EV to compare returns between businesses, as above. They also use the EV valuation (or a debt free cash free valuation) to determine how much to pay for the whole entity (not just the equity). They may want to change the capital structure once in control.

Technical considerations

Data availability

Unlike market capitalization, where both the market price and the outstanding number of shares in issue are readily available and easy to find, it is virtually impossible to calculate an EV without making a number of adjustments to published data, including often subjective estimations of value:

• The vast majority of corporate debt is not publicly traded. Most corporate debt is in the form of bank financing, finance leases and other forms of debt for which there is no market price.
• Associates and minority interests are stated at historical book values in the accounts, which may be very different from their market values.
• Unfunded pension liabilities rely on a variety of actuarial assumptions and represent an estimate of the outstanding liability, not a true “market” value.
• Public data for certain key inputs of EV, such as cash balances, debt levels and provisions are only published infrequently (often only once a year in the annual report & accounts of the company).
• Published accounts are only disclosed weeks or months after the year-end date, meaning that the information disclosed is already out of date.

In practice, EV calculations rely on reasonable estimates of the market value of these components. For example, in many professional valuations:

• Unfunded pension liabilities are valued at face value as set out in notes to the latest available accounts
• Debt that is not publicly traded is usually taken at face value, unless the company is highly geared (in which case a more sophisticated analysis is required)
• Associates & minority interests are usually valued either at book value or as a multiple of their earnings.

Avoiding temporal mismatches

When using valuation multiples such as EV/EBITDA and EV/EBIT, the numerator should correspond to the denominator. The EV should therefore correspond to the market value of the assets that were used to generate the profits in question, excluding assets acquired (and including assets disposed) after the end of the financial reporting period. Examples of such changes in assets (capital employed) can include mergers and acquisitions (whether paid in cash or equity), significant capital investments or significant changes in working capital. Ideally, multiples should be calculated using the market value of the weighted average capital employed of the company during the comparable financial period.

When calculating multiples over different time periods (e.g. historic multiples vs forward multiples) EV should be adjusted to reflect the weighted average invested capital of the company in each period.

See also

• DCF, discounted cash flow method of valuation
• Capital structure
• WACC, weighted average cost of capital
• Social accounting
• Residual Income Valuation
• Enterprise Value Tax