Enterprise Value Less Than Equity Value

Assume that all we know about a fictional company is below:

Market cap = 100
Debt=0
Short-term securities=50

Therefore...equity value = 150, EV = 50

How could it ever be the case that Equity value and EV differ like this? What am I misunderstanding?

How Can EV be Smaller than Equity Value?

Yes - EV can be less than equity value if net debt is negative. Net debt is calculated as total debt minus cash. If your cash balance is larger than the debt of the business, preferred shares and minority interest of the company combined then you will have an EV smaller than your equity value. This is not uncommon for profitable businesses without debt.

What is Enterprise Value?

Enterprise Value (also known as EV) is a metric that attempts to reflect the market value of a firm. It can be used as an alternative to market capitalization.

Essentially, enterprise value attempts to provide a more accurate valuation for a buyer. While a firm’s market capitalization will indicate share price x share quantity, the firm may have a lot of debt which the acquirer would need to pay off (thereby adding the price of the transaction).

The calculation for enterprise value is: Market Capitalization + Debt + Minority Interest + Preferred Shares – Cash & Cash Equivalents

What is Equity Value?

Equity value is another term for market capitalization and can be calculated as share price x shares outstanding.

How to Get From Enterprise Value to Equity Value?

Enterprise value + cash & cash equivalents - debt - minority interest - preferred shares will equal equity value.

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MD8:
In your example, equity value is 100, not 150. Enterprise value is 50.

Enterprise value is less than equity value when net debt is negative. In your example, cash > debt, thus the decrease in enterprise value. Not at all uncommon, especially for companies that do not use leverage.

But then you are saying the equity value is less than the cash on the balance sheet?

 
couchy:
MD8:
In your example, equity value is 100, not 150. Enterprise value is 50.

Enterprise value is less than equity value when net debt is negative. In your example, cash > debt, thus the decrease in enterprise value. Not at all uncommon, especially for companies that do not use leverage.

But then you are saying the equity value is less than the cash on the balance sheet?

Market cap is equity value.

Market cap = equity value = $100 in your example Enterprise value = market cap (equity) plus net debt = 100 + (0 debt - 50 cash) = 50 EV

EV is the value you would need to pay to acquire the business, net of cash / debt (and excluding control premia, etc.)

 
couchy:
MD8:
In your example, equity value is 100, not 150. Enterprise value is 50.

Enterprise value is less than equity value when net debt is negative. In your example, cash > debt, thus the decrease in enterprise value. Not at all uncommon, especially for companies that do not use leverage.

But then you are saying the equity value is less than the cash on the balance sheet?

It has $50 in cash, equity value is $100. Last I checked 100 > 50....

 

If I was a buyer and a company had $100 worth of shares and a portfolio of short term securities worth $50 I just don't understand theoretically why I would pay less than $150 for this. I also don't understand why the short-term securities would reduce the price we pay for equity i.e. EV = 100 - 50

 

The short-term securities don't reduce the price you pay for equity. You stated the company has $100 of shares - thus, you would pay $100 for the shares.

Let's say you borrow $100 to buy all the shares - you now own the company, which means you own the $50 of cash as well. You now use that cash to repay part of the $100 you borrowed, so in the end, you only really needed to borrow $50 to buy the business. Which means the business is actually worth $50 - this is the enterprise value (EV).

 

you don't seem to understand the concept of market cap and what it represents.

"After you work on Wall Street it’s a choice, would you rather work at McDonalds or on the sell-side? I would choose McDonalds over the sell-side.” - David Tepper
 

Ok I think the best way to figure this out is to again come back to the fictional company-this should nail it. Ok so:

Market cap = 100 Debt = 0 short-term securities = 50

D+E = 100 therefore A = 100 therefore to acquire all of the company's assets we should pay 100 ... But EV = Market cap + debt - short-term securities = 100 + 0 - 50.. So poof the 50 of non-operating assets disappears into thin air and instead of paying for all of the company's 100 of assets we now just pay 50 and we get a portfolio of short-term securities for free. There was no debt to pay down so where did the 50 of non-operating assets go?

 

equity value technically can be negative - if intrinsic EV is less than net debt. Practically speaking, this means equity value is zero, because "negative" is a bit misleading - sounds like it assumes some cash outflow which it normally doesn't.

EV technically can be negative as well - say the company has deeply negative EBITDA with no prospect of turnaround and no valuable assets to sell - so whatever metrics or method you apply - EBITDA multiple, P/E, DCF, you end up with negative EV. Fair enough that company that generates only losses on operational level costs nothing - it is cheaper to shut the company down immediately.

 

You don't have a clue what you are talking about, this isn't about valuation and multiples..

1) equity value cant be negative since share prices can't go below zero.. 2) EV can go negative. Imagine a company that has nothing but 1 million dollar in cash. It can do nothing with that cash but to distribute that cash to its shareholders. However, when it would distribute the cash, the company has to pay 25% tax on that cash. Therefore, the shareholders would only think the company is worth 0.75 million for them and EV would be negative.

 

There are plenty of examples when liabilities of LLC are passed on to the ultimate shareholders. Namely, environmental liabilities in many European jursdictions are actually passed to shareholders of LLCs. So assume EV = 100, Net bank debt = 80, environmental liabilities = 30, you get equity value of minus 10... And it really means you have to pay those 10 (at least), you can't just leave LLC hanging. If you never came across such situations it doesn't mean they don't exist.

So on equity value you are wrong and on EV you agreed with me - are you still of opinion that I don't have a clue?

 

Yes, absolutely right. Another example (although never seen this in practice) when corporate veil is pierced is described here: http://www.nnybizmag.com/index.php/2013/01/07/shareholders-liable-for-u…

Hard to believe but it says that shareholders of some NY incorporated companies are liable for unpaid wages of employees of the insolvent company. So if the company has such liabilities outstanding and NPV of other cash flows is lower than these liabilities, clearly equity value of such company is negative (even if you get this company for free, you are still obliged to spend cash on settling these liabilities).

 
Best Response

So, we are learning about piercing the veil right now in my business associations law class. For closely-held corporations, I'm hesitant to say that it's "easy", but you could easily see a PE firm running into issues with it. I don't want to bore you with the whole test, but it is basically this. There are 8 factors that sort of test whether you're running it like a sole proprietorship or partnership. If that is so, then you move on to a second branch. If you were aware of a plaintiff's claim, and it would be unfair to force the plaintiff to seek satisfaction from the company(which can't pay or you wouldn't need to pierce the veil), then the court will pierce the veil, and hold you or the several shareholders personally liable for even a tort liability suit, and really in any area of law. Now to be fair, this wouldn't ever happen for a publically traded company because the first factors wouldn't be met. Can happen with subsidiary corporations though.

 
Radiohedge:

You don't have a clue what you are talking about, this isn't about valuation and multiples..

1) equity value cant be negative since share prices can't go below zero..
2) EV can go negative. Imagine a company that has nothing but 1 million dollar in cash. It can do nothing with that cash but to distribute that cash to its shareholders. However, when it would distribute the cash, the company has to pay 25% tax on that cash. Therefore, the shareholders would only think the company is worth 0.75 million for them and EV would be negative.

Since we are talking business here, your example for #2 is very wrong actually. Academic perspective: definition of EV assumes value on "cash free debt free" basis. So EV in your example should be zero, not negative, because the only cash outflow in your example arises from cash position which is not used in EV definition whatsoever. Even in a highly unlikely situation when taxable distribution is a legal requirement (can't think of such situation though), it merely means that Debt-like item is 0.25m, cash is 1m, equity value = 0.75m (logical, because that is what you get immediately upon acquisition of the company). EV is still zero. Practical perspective: EV is "intrinsic" value of the firm and it cannot be impacted by tax rate / tax regime of any particular investor. Some investor will have 25% tax rate, another will have 5% and the other will simply not distribute in a taxable manner, but will rather re-invest or lend without losing any dollar from the million.
 
Radiohedge:

You don't have a clue what you are talking about, this isn't about valuation and multiples..

1) equity value cant be negative since share prices can't go below zero..
2) EV can go negative. Imagine a company that has nothing but 1 million dollar in cash. It can do nothing with that cash but to distribute that cash to its shareholders. However, when it would distribute the cash, the company has to pay 25% tax on that cash. Therefore, the shareholders would only think the company is worth 0.75 million for them and EV would be negative.

If a company has $1M in cash as its only asset and it liquidates, the liquidation distribution is a return of investment and not a dividend, and depending on the investor's basis they would pay no tax on that distribution.

 

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