Enterprise value confusion?
Got asked this the other day and was pretty confused. Can someone help me out please?
Suppose you started a company and injected $50 million into it. What is the enterprise value of this company?
My answer: Equity value goes up $50, cash goes up $50 so EV is $0.
Question 1: Is this correct ie. EV = $0? Question 2: I replied $0 and then was asked "Does that mean an acquiror could purchase the company for $0?" I replied yes but what confused me then is ... isn't this free money?
Not sure what the correct answer is. Thanks.
As you see, EV = Equity Value + Gross Debt - Cash & Cash Eq. which means if a company that has an equity interest of $100 and cash balance of $50 is valued at 100 + 0 - 50 = $50 for EV. This means you can buy it with $50 cash, which is true indeed because you do not acquire cash from target during a deal. So in your case, yes, EV is 0, meaning the acquirer pays $0 to acquire your operations (which is nothing) and he won't take away your cash.
So is the target's cash dividended out at close of the transaction?
How is a target's working capital factored into the EV and equity value in an acquisition?
It's not free money. The acquirer wll give you $50 million in exchange for the company, and then he acquires the $50 million. I would't spend too much time on this becuase it's more of a teaser than anything useful.
acquirer buys the equity, which you say is $50. then gets all core and non core assets
Why does he buy the equity? Why doesn't he buy the entire company (and therefore look @ the enterprise value)?
Because in this example there is no debt so the equity represents the entire company
He is paying enterprise value of 0 and equity value of 50. He pays $50 in cash for a box with $50 cash in it. EV=0 because on a net basis he paid 0.
Enterprise value represents the value of the net operating assets of a business, i.e., the value associated with the core operations of the business. For example, imagine I have in my pocket a brand-new Hermes wallet with a retail value of $300. In my wallet, I have a $100 bill. While the total value of the objects in my pocket is $400, the value of the wallet itself (the core asset) is still only $300.
If you were to offer to buy my wallet from me in its current state (including the cash, and ignoring any premium/(discount)), how much would you have to pay for it? This leads to an important distinction between the total "transaction value" and the actual "price" paid in the transaction - a distinction that is often presented ambiguously in WSJ articles, press releases, and interview guides. The actual "transaction value" corresponds with what we have been referring to as enterprise value - the core value of the operating assets acquired. In our example, the transaction value is just $300 - the value of the wallet you are acquiring from me.
By contrast, let's define "price" as the actual consideration you must pay me out of your own pocket - in this case, $400. Where does that $100 discrepancy come from? In this case, it is the $100 I already have in my wallet. At the close of the transaction, you will immediately get the $100 back, but the total amount of cash that will have left your hands at the onset of the deal is $400. This example illustrates why equity value implicitly accounts for cash, while enterprise value does not.
Now, to put this back into the context of a business, and your original question: when acquiring a business for control, you are essentially buying out the existing equity and replacing it with your own. The value of the net operating assets (enterprise value) is what you are gaining, but the equity purchase price is what you are actually "paying." In your example, the enterprise value is in-fact $0. Since the business simply has $50 in cash and $50 in equity, the value of its net operating assets is indeed $0. Despite that, in order to take control of that $0, you must "pay" $50 in order to wipe out the existing equity and replace it with your own. Much like in our wallet example, cash must leave your hands at the onset of the transaction, but it is immediately refunded with the cash already on the balance sheet.
Yes - you could acquire the company for a transaction value of $0, but the out-of-pocket "cost" would be $50 to effectively invest your own cash as equity, taking control of the company.
Not the hero we deserved, but the hero we needed.
This is a brilliant explanation! Thank you so much. +SB. So just to confirm, I answered question 2 wrongly because I actually needed to pay $50 correct?
That's right. Again, the word "pay" is often ambiguous in these contexts, but with how we've been using it, I would say that "pay" corresponds with the $50 cash outlay that equates to the equity value.
Great explanation, but I would argue heavily against that wallet being worth more than $50 for the core asset and then another $250 in goodwill.
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