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EV = Equity + Debt - Cash

Why do we subtract cash?
Shouldn't we be paying for the cash on hand too? If I am selling my company, why would I pay someone to take my excess cash?

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Comments (31)

  • JMu's picture

    You're looking to calculate the VALUE of a company through EV. In broad terms, value of a company is assumed to be the present vale of its future cash flows. The excess cash on the books (not all cash is excess cash) is assumed to be a non-operating asset. It does not aid in generation of future cash flows and therefore does not contribute to value. That is why it is subtracted.

  • collegekid89's picture

    Let's assume we have Company A and Company B, same Market cap and debt.

    Only difference is Company A has 0 cash and Company B has $500 million free cash.
    Company B's enterprise value would be LOWER because we have to subtract out cash??

  • PossumBelly's picture

    It is a non-operating asset, but also accounted for in the equity value...and really we're talking about subtracting excess cash, but it is usually assumed that cash balance is the excess cash.

    Think about it from an acquisition perspective, the buyer would get the target company's cash as part of the deal, effectively lowering the price to acquire the firm.

    To your point, you could have a negative EV in the case of a large cash balance (a bank, por ejemplo).

  • collegekid89's picture

    i just dont understand the logic of how it would be cheaper to acquire a firm with a billion cash versus a firm with no cash.

  • Leidenschaft's picture

    Think about it intuitively, what is EV?
    EV is the price you have to pay to pay off every stakeholder (i.e. equity and debt holders).
    Let's say you have company A with 1 $ in equity, 10$ in outstanding loans and 5$ in cash.
    So, you buy the company for 11$ (1+11) and have 5$ of cash left which you get to pocket, so you effectively only paid 6$ (11-5).

  • jec's picture

    imagine paying 5 bucks for a 5 dollar bill, you're actually paying nothing.

  • In reply to jec
    collegekid89's picture

    foreveralone:
    imagine paying 5 bucks for a 5 dollar bill, you're actually paying nothing.

    yeah but what i pay -$5 for $5

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  • collegekid89's picture

    Forever alone said imagine paying $5 for $5...

    But we aren't paying for $5. We are subtract $5,.....

  • Something Creative's picture

    The cash you pocket would be used to pay off the debt. So the acquisition price (The EV) would be lower since you get a bunch of cash to use to help you pay off all the debt.

    If I sell you a pencil and $10 for $15, what are you actually paying for the pencil? (hint- $5)

    That help?

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  • ankit.agrawal's picture

    I agree with collegekid89 . suppose I just start a company that has only $5 cash.
    now the market cap will be $5 and cash also $5.

    if we go by EV concept, it will have EV = 0. and we will pay 0 to get that company and get $5 for free.

    isn;t this wrong ?

  • trazer985's picture

    Yes you've found the flaw in the equation and can now profit hugely for it, go and buy apple for $85bn less than its currently valued at, take the money out and sell it for $85bn more, instantly worlds richest person.

    cash is usually stripped out of a business when it is sold. it has no value beyond its face reserves, and is included elsewhere in the valuation.

  • notamonkey's picture

    I thought I'd give this a go despite the prior valid explanations falling flat for our young apprentice:

    Company A has a market cap of $10 and it has $5 in cash and $2 in debt. You, the astute investor that you are, want to acquire Company A. Let's pretend you can buy all the shares at the current market cap of $10.

    So you bought the company for $10. So far you've spent $10. Still following?

    Now you decide to pay down all of the debt, so you use $2 in cash to pay down $2 in debt. Since that cash money already resided in the corporation that you purchased, you didn't have to spend any more money out of your own pocket to pay down the debt. You've still spent just $10.

    Now you decide to pay yourself a dividend with the remaining $3 in cash on the company's books. So you pay yourself a $3 dividend. Let me add that you did all of this -- paying down the debt and paying the dividend -- on the same day that you bought the company. So now that you receive $3 in cash, you can subtract that from your purchase price. $10 - $3 = $7 (you can check this math on a calculator). So, your effective purchase price is Market Cap + Debt - Cash, or $7.

    All I care about in life is accumulating bananas

  • In reply to notamonkey
    oreos's picture

    notamonkey:
    I thought I'd give this a go despite the prior valid explanations falling flat for our young apprentice:

    Company A has a market cap of $10 and it has $5 in cash and $2 in debt. You, the astute investor that you are, want to acquire Company A. Let's pretend you can buy all the shares at the current market cap of $10.

    So you bought the company for $10. So far you've spent $10. Still following?

    Now you decide to pay down all of the debt, so you use $2 in cash to pay down $2 in debt. Since that cash money already resided in the corporation that you purchased, you didn't have to spend any more money out of your own pocket to pay down the debt. You've still spent just $10.

    Now you decide to pay yourself a dividend with the remaining $3 in cash on the company's books. So you pay yourself a $3 dividend. Let me add that you did all of this -- paying down the debt and paying the dividend -- on the same day that you bought the company. So now that you receive $3 in cash, you can subtract that from your purchase price. $10 - $3 = $7 (you can check this math on a calculator). So, your effective purchase price is Market Cap + Debt - Cash, or $7.


    just to clarify, paying down debt is rarely optional, it's a legal requirement baked into the debt contracts

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  • In reply to ankit.agrawal
    notamonkey's picture

    ankit.agrawal:
    I agree with collegekid89 . suppose I just start a company that has only $5 cash.
    now the market cap will be $5 and cash also $5.

    if we go by EV concept, it will have EV = 0. and we will pay 0 to get that company and get $5 for free.

    isn;t this wrong ?

    I have a lemonade stand except I don't have any lemonade or other assets. All I have is a $5 bill. You come along and buy my "lemonade stand" for $5. What is your net purchase price?

    (It's $0).

    All I care about in life is accumulating bananas

  • In reply to notamonkey
    ankit.agrawal's picture

    notamonkey:
    ankit.agrawal:
    I agree with collegekid89 . suppose I just start a company that has only $5 cash.
    now the market cap will be $5 and cash also $5.

    if we go by EV concept, it will have EV = 0. and we will pay 0 to get that company and get $5 for free.

    isn;t this wrong ?

    I have a lemonade stand except I don't have any lemonade or other assets. All I have is a $5 bill. You come along and buy my "lemonade stand" for $5. What is your net purchase price?

    (It's $0).

    I got the point, but then while actual selling of the organization there should be some mechanism to freeze the cash or investment after the deal has been closed at a given price.

  • Jeremystory's picture

    What we are subtracting here is actually Excess Cash; however, we typically make the assumption that a company's cash balance equals excess cash. Excess cash has been reflected in equity value, and it belongs to Equity Holders. Based on the definition, excess cash is what remains after making payments to all other claimholders. The company will benefit from the excess cash because if they don't have excess cash, they may have a liquidity crisis in bad times, or may have to raise extra funds at higher costs. Investors will reward those companies that use Excess Cash well, thereby increasing its Market Value.

    Envision, create and believe in your own universe, and the universe will form around you. -- Tony Hsieh

  • idragmazda's picture

    Think of it as "Net Debt".

    Say you have $200M in Equity, $100M in Debt, and $50M in Cash. Therefore:

    EV = $200M of Equity + $50M of Net Debt = $250M
    EV = $200M + $100M - $50M = $250M

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  • yoursrohan's picture

    @collegekid89 & @ankit.agarwal & rest-

    I see this discussion has been on since 2011 - my shot at solving the same:

    I agree with you that the EV will be "0" - but PLEASE REALISE WHAT WE PAY TO ACQUIRE IS EQUITY VALUE & NOT ENTERPRISE VALUE - so in Ankit's case, we will pay $5 and in return will get $5.

    Coming to the question of why we deduct cash in EV, think like this - say you purchase a flat for $2million and also need to service the balance debt against the flat of say $3million; also in that flat there is $1million lying around.

    How much would you pay the owner? Ans. $2million; but effectively you paid the owner 2m - 1m = 1m only, right? This is equity value.

    How much did you pay for the ownership of the flat? you effective paid $1m to owner and also assumed the $3m debt, so $4million - right? This is enterprise value.

    So, reiterating my first line above, YES THE BUYER WOULD BE PAYING YOU FOR THE CASH LYING IN YOUR BOOKS - HE WOULD DO SO BY PAYING YOU (EQUITY HOLDER) FULL MARKET VALUE (which reflects the cash balance as well) - he will be paying you MARKET VALUE and NOT ENTERPRISE VALUE.

  • Bharat2121's picture

    Is there a difference between cash treatment when calculating EV through FCFF Vs. the EV computed through the trading data available for a listed firm?
    eg. FCFF will only value operating assets so you'll need to add excess cash (i.e. non operating assets) to equate it to the EV the stock trade is valuing it at. Is this correct?

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