Cash in Enterprise Value Bridge
When reading the M&I Equity/Enterprise Value guides, I'm a bit confused about what the more appropriate answer is to a question about why we subtract cash in the EV bridge. Is it:
1) because cash is a non-operating asset and EV reflects the value of the business's core operations
or
2) because cash effectively makes an acquisition cheaper since it could automatically be used to pay off debts, pay dividends, etc.
These seem like relatively different answers and the guides tend to contradict themselves so I'd love some clarity. Thanks!
There is some confusion as to why cash is subtracted.
My take:
Enterprise value is the value of the company as a whole, taking into account debt and equity. When someone buys a company, it is assumed that they will use the cash reserves to pay off the debt, thereby reducing the enterprise value.
Excess cash is a non operating asset. As enterprise value can be calculated in a way to depict its intrinsic value (discounting future cash flows), cash is deducted as it does not form part of this process.
There may be other intuitive reasons on top of these.
However, enterprise value is better seen to be calculated using relative comps (EBITDA multiples) or DCF.
Equity value (actual amount paid to shareholders) is seen to be calculated as
Enterprise value + cash - debt (seperate reasons for this).
The formula you listed above is a rearrangement of this formula and enterprise value can be better calculated using the methods listed above.
Hope this helps!
To be very precise, we're talking about excess cash (since you could call the minimum cash the firm needs to operate an operating asset)
I would update your first bullet to say enterprise value represents the value of a firm's *operating* assets. Picture a balance sheet with (1) non-operating and operating assets on the left, and 2) debt and equity on the right.
The enterprise value math solves for the operating assets by adding up everything on the right (ie debt and equity) and backing out the non-operating assets (eg excess cash, equity investments, most deferred tax assets).
In other words, op's first bullet is correct.
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