EV without debt
Can't seem to understand EV.
Suppose two few kids on the block run a lemonade stand. Their parents are rich and give them 100k cash as a handout without asking for any equity.
The kids split the equity 50-50.
Let's say future investors think they have no relevant experience so they value the equity at 1,000 bucks.
So according to EV we need to put up 1,000 - 100,000 = -99,000 to purchase this company. In other words we should be paid -99k to take this company off the kids' hands.
So obviously I don't understand this and I'm missing something here... please help.
You're over thinking this
If someone gives you $100k and asks for no equity stake, then that $100k becomes your equity stake (free money), so why would an investor give you $1000 for it?
What I meant was that the company just has a bunch of cash out of nowhere / picked up on floor. I thought it would be a good example for me to help understand this.
In other words, I'm trying to wrap my head around this EV concept, by thinking about a company with basically nothing but cash.
Commenting again cause I recognize your confusion. You are thinking of EV as Equity Value+debt-cash, which leads you to believe that, without debt, EV should be equity value-cash. This is incorrect— cash needs to be thought of in terms of debt, together creating “net debt”. A way this is often described is that the only cash considered in this formula is “excess” cash, meaning cash that is essentially sitting on the balance sheet that could be used at any time to, say, pay off debt or repurchase shares, NOT cash that is required for operations. A way to look at it is, hypothetically, net debt is debt left over after some debt is immediately paid off using that excess cash, which is why we subtract cash.
In terms of your example, $100,000 cash is worth $100,000.
In it’s simplest form, EV= equity value + net debt. If there is no debt, then EV= equity value. According to this example, so long as the company was just capitalized with that $100,000, then EV=equity value=$100,000. If a buyer offered $1000 for the company and the seller agreed (idk why they would do this— maybe in this example we can say the owners just payed out a 99% dividend to themselves), then the buyer would simply pay the agreed upon price, EV.
When the kids receive the 100k cash, this is recognized as an "extraordinary" line item. Effectively the equity value goes up by the same amount that cash does (balance sheet must balance, so assets (cash) going up means equity (absent liabilities) must go up the same amount), so there is no net effect on EV. For EV to actually increase, you need to have net operating assets increase; financing (the cash windfall, in this case) has no effect on changing EV. Assuming this is a conceptual lemonade stand, the EV here is still zero because the lemonade stand business has no net operating assets (or liabilities); it is literally comprised of 100k cash.
As a result, the investor would be losing out if he/she offered any amount greater than zero for purchasing the business. Suppose the investor bought the business for $1. Then post-buyout the implied equity would be $101 and the business now has $100 cash and $1 goodwill. But one would argue that the goodwill is kind of pointless given that there's no actual intangible brand premium; hence, the investor has thrown $1 up in smoke. Practically, the investor would then just take the $100 cash and render the company defunct (reduce equity value to zero); and this is technically free money, so this is why the example is just an example and not reality.
Thanks for the detailed comment. It seems your explanation is in the same vein as Hominem's below. I guess I just didn't know that a cash increase automatically means an equity increase, assuming it's not borrowed money.
So for me the hard thing is understanding "buying a company" in the sense of Enterprise Value--maybe many non-finance folks would have the same confusion I've only ever conceived of "buying a company" in terms of stocks/equity, but I never think of equity in its accounting definition(hopefully that makes sense). So the idea that buying a business=owning it completely is ingrained.
Which is why I found it difficult to understand the $1 example, but after some thinking I came up with this:
- Really try to separate the idea of Enterprise Value from Equity Value. So when you say the business is really worthless because EV = $100 Equity - $100 Cash, that means it's worthless b/c it's literally not a business. So theoretically no one should want to buy this thing. This part I understand.
- What I don't understand is--we can buy the equity at a fair price right, so we would pay the existing shareholders $100 in exchange for $100 in cash. So no arbitrage there. But if the 'business' is truly worthless and the owners are theoretically indifferent between keeping it and giving it away (since EV=$0), why can I take over the business for free and receive $100 cash...? I get that you said this is just a fantasy example and it wouldn't happen in real life. But is there some way you could help me understand my confusion.
Let's use a simpler example. You have a lemonade stand that is not worth anything. The value of your lemonade stand would be your EV. In this case, your EV is zero. Your equity value is also zero.
Next, you find a $100 bill on the street. You put the $100 in the tip jar on your lemonade stand. Your EV is still zero, because the $100 is not considered an operating asset. However, your equity value is now $100 (= EV + cash - debt).
If someone wanted to buy the lemonade stand from you, they would offer you $100. They would pay nothing for the business itself (because, it is worthless) and $100 for the cash in the tip jar. If someone offered you $10 for the lemonade stand, you would obviously turn them down.
Hope that helps.
This is awesome, thanks - think I get it now.
But how would you reconcile this with Wentworth's comment: "Commenting again cause I recognize your confusion. You are thinking of EV as Equity Value+debt-cash, which leads you to believe that, without debt, EV should be equity value-cash. This is incorrect— cash needs to be thought of in terms of debt, together creating “net debt”?
In your example we moved the EV equation around to get the Equity Value equation, absent of debt. But Wentworth's comment would suggest that's not the case.
- Your example: Equity Value = $100(Cash) + Enterprise Value(0) - Debt(0) = $100
- Wentworth's example: Enterprise Value = Equity Value+Debt - Cash BUT since there is no debt, --> Enterprise Value = Equity Value. Which would then mean Enterprise Value = $100 since our equity value increases exactly by the amount of cash injection. So I think Wentworth was driving at something but now I don't quite get it.
Wentworth assumes that the $100 is spent to purchase operating assets for the business (e.g., lemons, cups, a table). Hence, net debt is zero. EV = $100.
I assume the $100 is sitting in the tip jar as a non-operating asset. Hence, net debt is -$100. EV = $0.
In both cases, equity value = $100.
Also a related question.
Is there some way to think of operating assets in relation to cash?
So it seems like cash is this special thing different from assets. But aren't assets just... stuff bought from cash? On a high level could you help conceptualize the difference between assets and cash if that makes sense.
For a non-financial business, cash is considered a non-operating asset because cash itself is not core to business operations. All other assets are usually considered operating assets. The value of a business (i.e., enterprise value) is the PV of the cash flows generated from these operating assets.
So if you leave the $100 in the tip jar and do nothing with it, EV does not change. This is why EV remains $0 even after finding $100 on the ground (however, equity value increases from $0 to $100). However, if you use the $100 to purchase assets that will produce cash flows for the business going forward, then the EV will increase from $0 to $100.
Hope this helps.
In the Enterprise Value = 0 Case, where Equity Value = Cash Windfall = $100.
One way I've been able to explain to myself is this:
Right before you buy this "business", the equity holders would pay out a $100 dividend to themselves. So that makes sense: You wouldn't be able to arbitrage this by buying the business for $0, liquidating it and getting the $100 cash.
But I still don't get it, assuming the equity holders don't pay out the dividend.
- Maybe we could say, since this cash was pure windfall, the equity holders are theoretically not "entitled" to the cash? So unlike the case where they actually put up their own cash, they wouldn't mind giving it up. But that doesn't explain the case where it's not a windfall and the business is just a few friends who pitched in 100 bucks but no assets yet.
Is this just a flaw of the Enterprise Value concept? I know it's just a valuation model after all, and it's not able to explain all cases.
Don't complicate things.
Let's use an even simpler example than the lemonade stand. If you had a wallet that was worth nothing (EV=$0) but it had a $100 bill in it, how much would you sell it for?
Well, you could take out and keep the $100 bill and then sell the wallet for free (this is your dividend out the cash example). Or you could sell the wallet for $100, and then hand over wallet with the $100 bill inside.
In both cases, as a seller, you would wind up with $100 (equity value). It does not matter whether the $100 bill inside the wallet came from a windfall or if it was yours to begin with.
Hope that helps.
Thanks for being patient with me. I understand the Equity component. But for the EV component, the wallet = EV = 0 right? So theoretically it costs 0 to buy the wallet, but $100 for the equity.
So if the equity holder leaves the cash in and we buy the whole wallet—wouldn’t it cost 0 and not $100? And wouldn’t we arbitrage $100?
When you buy a house, for say $1mm and put in $200k of your own money they Enterprise Value is $1mm and the Equity Value is $200k. The house is still worth $1mm no matter what % of Debt/Equity you put in it.
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