What is the correct method to derive Equity Value (Theory vs practice)
Hi there, I am a little confused about the following scenario that was asked during an interview. To my knowledge, the following are two ways to arrive at an Equity value for a firm:
1) Enterprise value = Equity value + Debt + Preferred stock + minority interest - Cash and cash equivalents, where we do a DCF on FCFF to arrive at enterprise value first and then use the above equation to arrive at equity value
2) Doing a DCF on FCFE, using the cost of equity as a discount rate and using the firm's target structure when calculating the beta in cost of equity
My question is, when do we use which method and are we supposed to reconcile the end values for both methods?
Based on your question I'd suggest really spending a lot more time on reading through the basics and theory for valuation and concepts like enterprise and equity value.
Nonetheless, will give a short answer which should be read assuming you do the above.
A valuation is based upon a/several methods and results in either an enterprise or equity value output (eg a dcf with fcff gives you ev, trading comps on p/e gives you eqv, etc., However most valuation methods are to enterprise value given its comparability on a capital structure agnostic basis).
Once you have your valuation you use the EV-EqV bridge like you describe to imply the EV or EqV depending on what you solved the valuation to.
In terms of what you're saying, part 1 isn't wrong at first glance. And part 2 sounds like a dividend discount model to fcfe which is also a method. But what sounds wrong is that you don't understand the concepts well and didn't recognise that there are many ways to drive EV or EqV beyond those two and probably made that apparent to the interviewer.
Hi there, thanks for the explanation.
Could I clarify which part of my concepts is lacking, so that I will know which parts I need to study more? I understand there are other valuation techniques to arrive at EV and EqV, such as trading comps and precedent transaction analysis. The reason I only brought up dcf and the bridging question was because the interviewer's question was only centered around those.
If I remember correctly, he was asking what the possible reasons were as to why the implied EqV would not reconcile with the value derived from a dcf of fcfe. So far after research, the possible reasons I could think of are that the cost of equity uses a constant target capital structure of the firm, which is an assumption that does not hold when deriving your implied EqV due to changing capital structure, an example being due to changing repayment schedule. However, I have not been able to find other satisfactory answers thus far.
Thanks again and appreciate all the help given.
Ok I understand the question better now (the original post sounded like you had volunteered these two as the only methods for calculating EV or EqV intrinsically but sounds like a tricky question set to you) so apologies that my last answer was high level and assumed you thought these were the only ways to value companies.
It sounds like the question they're asking assumes that in in theory the two intrinsic methods here should give the same result mathematically (like in excel) and that we're being asked to figure out why that might not be the case then?
If so, there's only two things the interviewer really says about method two to go on.
Let's start with the second point that method two uses CoE using target capital structure. I think this could be a red herring since in theory you should always use target capital structure when calculating beta for CoE (including in the wacc for method 1). But would say this to make it clear you know that and that particularly to the extent your target company is sub optimally capitalised that target structure should be used to adjust discount rates in either method (across beta, target leverage ratio and normal cost of debt). Just in case this is part of it.
The first point is that they say that they use the CoE as the discount rate in method 2. So the real point here is that the second method's wacc is higher than the first (given it doesn't have any low CoC debt in structure) and cash flows are lower in method 2 (since fcfe is smaller than fcff) but the first method has an EV-EqV bridge.
So then it's about poking at what could drive these differences. For example, could the cost of debt used in the interest calc in the fcfe method be too high vs. the cost of debt assumed on the first method's wacc applied to fcff? There's also questions about whether the very specific and basic adjustments they gave for EV-EqV for method 1 are included/reflected in your calculation of interest cost and capex (eg right of use asset accounting being reflected or discount rate used to calculate the finance lease liability in the bridge vs. the wacc in our intrinsic method if we include lease cash flows, etc.).
In short, this is a tricky question so quite a tough one. Don't sweat it I think.
May just be me - but don’t think this addresses the question at all (and comes off somewhat condescending). It’s a technical question asking why two (independently valid) methodologies would spit out different equity values (with a focus on capital structured, discount rate, etc).
Yes, you're right. Now that OP followed up to explain that the two methods were the ones the interviewer asked them to reconcile have followed up with my view on the technical answer to this question.
And just to add you should use the method(s) that give you the most accurate valuation and/or reflect the purpose of the valuation (eg an lbo for a financial sponsor).
The reconciliation between the two or more methods is the point of the football field. The methods don't all reconcile, its a question of triangulation
Bump on this - they aren't meant to fully reconcile
As mentioned by others there is a difference between market value (multiple-based valuation) and the intrinsic value of a firm.
What you need to realize is that Enterprise value = PV of all cash flows to the firm
All cash flows to the firm (Enterprise value) = Cash flows to equity discounted at cost of equity + Cash flow to debt holders discounted at cost of debt
This also means you can calculate the value of equity directly by discounting FCFE at cost of equity, or by rearranging the equation and calculating equityvalue as FCFF discounted at WACC (Enterprise value) and subtracting cash flow to debt holders discounted at cost of debt (I.e. net debt).
The two will always give you the same answer.
I second the feedback on your command of these concepts. If I were interviewing you and you just recited a formula to walk from Enterprise Value to Equity Value, I'd give you like a C- at best. In real life, there are tons of other items you might need to add or deduct (e.g., capital leases, unfunded pension liabilities, deferred tax assets, equity in associated companies, a whole slew of other non-operating assets).
I'd assume you’d miss these if all you did was recite a formula.
A better approach is to say something like "enterprise value is the market value of a company's operating assets. You typically calculate it as (1) the market values of debt and equity, plus (2) all the debt-like claims on the cash flows, minus (3) all the non-operating assets. Equity value is the residual claim of common shareholders on all the assets, so you add back the non-operating assets and back out all the debt and debt-like items."
You could give examples of each for bonus points, but you don't have to. This answer proves you actually know what's happening conceptually
Neque voluptate porro rerum et laboriosam dolor consequuntur. Harum repudiandae totam sit unde voluptatem id praesentium. Quis doloribus libero et soluta omnis iste. Exercitationem voluptas omnis incidunt ullam explicabo dolorum maxime.
Omnis sapiente dolor rerum modi. Magni quam ipsam consequuntur omnis praesentium. Et doloribus est reiciendis et aperiam.
Dignissimos aut doloremque aperiam rerum ad in in doloribus. Quasi molestias nobis quia soluta qui ducimus id aspernatur. Dolor enim deserunt eos iste. Voluptates sint ipsa assumenda vero saepe voluptatem cumque. Corrupti nam ipsam ipsa deleniti eaque ut. Sequi sunt cum autem sequi culpa et ipsum. Vitae necessitatibus voluptas est repudiandae dolores.
Aliquid voluptate laborum laudantium velit. Eum ipsam quasi rem voluptas. Consequatur voluptatum occaecati repellat porro. Commodi nesciunt vel dicta qui expedita quia et. Ut sint impedit dolor quia. Beatae quisquam quos inventore rerum. Distinctio perspiciatis ab id qui quia necessitatibus fuga.
See All Comments - 100% Free
WSO depends on everyone being able to pitch in when they know something. Unlock with your email and get bonus: 6 financial modeling lessons free ($199 value)
or Unlock with your social account...