Understanding Enterprise Value, Help??
Hey,
I have an interview and I really can't understand why we add debt to equity value on the enterprise value. Doesn't the equity value already automatically discount the debt and thus only the real amount to be paid is left? I read that the buyer always was to pay for the debt but I just can't understand why...
Does anyone has an example where its more clear?
Thanks
"Doesn't the equity value already automatically discount the debt and thus only the real amount to be paid is left" - I'm not sure what you mean here. Either way, we add net debt because the buyer assumes the debt of the company since these debt holders need to be paid off unless its a debt-free cash-free transaction where the sellers pay the debt after being acquired. Look at it this way If the company has 10m in debt and its total outstanding shares is 100m, and 5m in cash, its EV is 105m because you purchase it for 110 - of which 10 million is paid to the debt holders and since you acquired 5m in cash you technically paid only 105m. However, I think where you're going wrong is assuming the EV is the actual purchase price when it is not.
The transaction can be structured in multiple different ways to not include or include debt. Since if the buyer just paid the seller 100m which is the equity value as the purchase price the sellers would then have to pay off the debt of 10m and would net 90m or 95m depending on who owns the cash. And that is not what the equity is worth (worth 100m) and therefore it would be acquired at a discount
So it's basically as if I brought forward all the debt payments I would need to pay in the future if I only bought the equity today?
That sentence doesn't make sense to me. But If you mean that you pay for the seller's equity and then also the debt to the lenders today then yes.
I think what I'm thinking of if the equity value as net equity (already taking the debt) and I don't get why we need to add it back
If you were to be acquired at net equity you've now sold your equity at a lower price than what it is valued at. If the seller wants 100m after 10m of debt is paid off the buyer has to pay 110m. If the buyer were to just pay the seller 100m as the EV the seller would only get 90m since they have to pay off the debt, but if they pay 100m for the equity and the buyer says okay we will pay the debt they have now paid 110m but the buyer still only gets 100m
EV is a fascinating concept. There are two faces of the same coin which you should always bring up during interviews to look cool:
1) EV is the value of net operating assets. Look at manufacturing facility of a company and think about the machinery, inventory in the warehouse, etc. That, net of operating liabilities is the EV. Cash is generally not considered an operating assets. If the CEO on the way to the office finds $1M in a brief case, EV does not change as cash is not an operating asset.
2) Think about the other face of the net operating operating assets described above. Who owns 100% of them? Equity + Debt. So the common way to look at EV is looking at the net claims on the net operating assets. It is the same concept as the balance sheet which always have to balance. The reason cash is subtracted is the same as above but the calculation is different. If the CEO finds the same $1M brief case, cash goes up by $1M, Equity goes up by $1M, and thus EV does not changes.
Hope it helped. I have scouted this forum left right and center during my interview days to arrive at the easiest and cleanest way to conceptualize EV.
Now to further clarify, let me add this and let's answer the classic question of "when buying a company, do you pay the EV or Equity Value"? it's a classic one for PE, PD and IB.
The answer should be always EV. This is because 99.99% of the times, the debt instruments of the company you are acquiring have change of control provisions. These provisions to put it simply state that when a new owner comes in, you have to re-finance or repay the existing debt. The provisions are there because banks and debt funds are as risk adverse as you can be and do not want to have to think what a new owner might do with the company. There are rare instances in which these provisions might not be there or will allow you coming in without refinancing, but they are so rare that are not worth mentioning in an interview at the analyst or even associate level.
Now, buying at EV price does not mean that the PE fund or company would actually have to use all those money. They will raise a big chunk of debt (always done by PE fund and sometimes by strategic acquirers as well) and only use a small portion of equity (20-30% on average). So if Apollo wants to buy a company that has $100M of EV, it will use around $30M of its own money (called equity cheque) and for the rest it will take loans from different banks, private debt funds etc. for the remaining amount of $70M. After the transaction the new company will have an EV of $100M, 30% equity and 70% debt.
Hope it is clear. Good luck!
eah, my thinking was this: My company has 100M in Assets and 50M in Dept. Net Equity = +50M. I would pay the 50M for the company and get the assets and the debp.
So if there is a company valued at 100M. Assets of 100M and debt of 10M, is it wrong to assume the value of the company is 100-10=90M and then divide that buy the shares outstanding to get a margin of safety, ie, a new equity per share? Here I'm assuming there are no future cash flows to discount.
I also don't understand something. There are two competitors, with exactly the same businesses and market cap, lets say 100M. One has 0 debt the other has 50M in debt.
According to EV it's more expensive to buy the one with 50M in debt, for a total of 150M. So why would anyone buy this one if they can buy the exact same business and pay just 100M?
You made a conceptual mistake mate. How can they both be "exactly the same" with "same market cap" but different level of debt? They can't. One is larger than the other because it has more "net claims" which means that its operating assets are larger/bigger. So yes, it is more expensive to buy the one with the debt because is a bigger company with bigger operations.
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