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The true purpose of calculating Enterprise Value
 

uoft2013's picture
(Monkey, 54
 
Points)
 on 8/26/12 at 4:05am
enterprise value.jpg

Hi guys,

Some sources call EV the "price that an acquirer really pays''. But in reality the purchase price is always the stock price plus certain premium. Does it mean that EV is just a 'theoretical price' for the business? If so why do we go through all the trouble gauging a company's EV, especially in an M&A transaction?

Thanks!

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Nabooru's picture

Someone buys a 100k house,

(Gorilla, 689
 
Points)
 on 8/25/12 at 8:27pm

Someone buys a 100k house, puts 20k down in equity and takes out a mortgage (debt) on the other 80k. How much do you have to pay for the house if you want to buy it? You pay 100k. You don't just buy out the owner's equity in the house, you have to pay the debt portion too. That's essentially EV.

Who are you going to believe, me or your lying eyes?

dogboo's picture

Its basically if you bought

 
Points)
 on 8/25/12 at 8:42pm

Its basically if you bought the company at its current market cap what you would pay.

You take on the companies debt so you add it and subtract the cash.

Beretta's picture

You need it for ratios such

ST
(Orangutan, 358
 
Points)
 on 8/25/12 at 8:39pm

You need it for ratios such as EV/EBIT and EV/EBITDA. You need both the denominator and numerator to reflect the same thing (which is the case here, since both EV and EBITDA are capital structure neutral).

Sandhurst's picture

You calculate EV to support

IB
(King Kong, 1,239
 
Points)
 on 8/25/12 at 9:35pm

You calculate EV to support your argument. Remember - IB valuation isn't really about "valuing" a company. It's about helping a client achieve the best transcriptional outcome.

So if you are advising a target, you might want to use an EV/EBITDA comparison (among other "valuation" "methodologies") with other companies to support your case that your client is undervalued by the market, and thus the buyer should pay a higher premium over the current stock price.

"There are three ways to make a living in this business: be first, be smarter, or cheat."

JeffSkilling's picture

You usually will have to

(King Kong, 1,911
 
Points)
 on 8/26/12 at 2:54am

You usually will have to refinance the target's debt due to change of control covenants.

knaegeli's picture

mdv11: Thanks for all your

O
(Baboon, 142
 
Points)
 on 8/26/12 at 10:39am
mdv11:

Thanks for all your explanation.
I still have a hardtime understanding why we should add the debt.

Nabooru:

Someone buys a 100k house, puts 20k down in equity and takes out a mortgage (debt) on the other 80k. How much do you have to pay for the house if you want to buy it? You pay 100k. You don't just buy out the owner's equity in the house, you have to pay the debt portion too. That's essentially EV.

Sure, but in that case, I will buy the house on a debt-free basis.
If not, this is equivalent to paying 100K for the house + assuming another 80K of debt liabilities to pay-off the mortgage - which means I basically paid 180K for a house that worths 100K.
When a Company is to acquire another Company, they usually don't do it on a debt free basis. Hence computing entreprise value as the acquisition price for the company is equivalent to paying 2 times for the debt (one time upfront and another time in assumed liabilities.

JeffSkilling:

You usually will have to refinance the target's debt due to change of control covenants.

Same comment here Jeffskilling. If I need to refinance the debt why would I take debt into account (i.e. using EV formula) for the transaction price.
Wouldn't it be more relevant to use Equity value as acquisition price and assume the Company's long term liabilities?

Thanks in advance for any explanation on that EV concept and usage.

Think of it this way:
Assume the current owner of the 100k value house owes 80k on it still. You have only 20k in the bank, so you borrow the other 80k. You use the 80k you borrowed to pay off the existing loan and the seller gets the 20k in equity. You are not double paying the loan, you've just refinanced it under your name. Alternatively, if you had 50k, you would borrow only 50k. 30k from your cash would go towards paying down the debt and you would effectively change the capital structure of the house to 50k equity and 50k debt. This is why EV is important to calculate, because it is capital structure neutral.

To your question on why you add the debt:
All of the assets are being transferred. Those assets were acquired using debt and equity (assets = debt + equity). In the house example, you're getting the entire house, not the 20% already paid off. If you were the seller, would you continue to pay the debt when you had no rights to the house?

BTbanker's picture

Last time i checked, Assets=

IB
 
Points)
 on 8/26/12 at 12:03pm

Last time i checked, Assets= liabilities +owner's equity. I suggest you take a basic accounting class. This is elementary math.

"A man generally has two reasons for doing anything. One that sounds good, and the real one." - J.P. Morgan

Not not a boutique's picture

uoft2013: Hi guys, Some

IB
 
Points)
 on 8/26/12 at 1:59pm
uoft2013:

Hi guys,

Some sources call EV the "price that an acquirer really pays''. But in reality the purchase price is always the stock price plus certain premium. Does it mean that EV is just a 'theoretical price' for the business? If so why do we go through all the trouble gauging a company's EV, especially in an M&A transaction?

Thanks!

My fault if its already been answered, but OP..here is an example:

First - you're correct on the purchase price. Its the market price, plus a "control premium" to acquire all of the equity in a company.

However, when that happens, you consolidate the target onto your balance sheet and (usually) assume all debt and cash.

So, the example:

If you buy your friend, for $100 (say, paid to his parents), but he has $20 in his pocket, your true out of pocket cost is actually $80...the enterprise value".

However, if your friend also has $50 in debt, along with the $20 in equity, you're now assuming all of that debt as well and the EV goes from $80 to $130. YOU'RE the one now responsible to pay for the interest on that debt, and the principal at maturity...it is now your property, along with the stock and cash.

So the use in EV is to show the company if the entirety is to be acquired. If you wanted to buy one stock in Facebook, you'd be paying the market price b/c you're simply acquiring part of the equity. However, when Google decides it wants to own ALL of Facebook, it has to account for that other stuff (the outstnding debt and cash-on-hand) as well.

labanker's picture

uoft2013: Hi guys, But in

PE
(Orangutan, 330
 
Points)
 on 8/26/12 at 4:41pm
uoft2013:

Hi guys,

But in reality the purchase price is always the stock price plus certain premium.

This is where you are going awry. The purchase price of the EQUITY in a business is the stock price (plus a premium), not the purchase price of the whole business. You still have to deal with the business' creditors, or you won't own the company.

Easiest way to think about it: Say John Doe buys $100 of assets. To pay for them, he borrows $60 from the bank (debt), and pays $40 out of his own pocket (equity). Say you come along and want to own John's assets for the same price he paid ($100). To do so, you have to pay two people: (i) $40 to John and (ii) $60 to the bank. The $40 to John is analogous to the price per share you see in public M&A deals, and the $60 is analogous to the amount paid to re-finance or roll whatever debt is on the business. Together, they comprise the total value of the assets, or the enterprise value.

BCbanker's picture

EV is capital structure

IB
(Gorilla, 633
 
Points)
 on 8/28/12 at 5:46pm

EV is capital structure agnostic. Its the apples to apples comparison. The first home buying analogy hit it on the head.

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