Valuation: non-operating assets & operating liabilities

RiseUp's picture
Rank: Chimp | banana points 6

Hey guys,

I am wondering about the correct theoretical explanation for two valuation-related issues and would be glad if someone could shed some light on these.

1) When going from Enterprise Value (EV) to equity value (EqV), we are adding non-operating assets and vice versa, we are subtracting them from EqV so as to get to EV. In conclusion, the value of non-operating assets is part of EqV, but not part of Enterprise Value. That's more or less what contemporary literature tells.
-> Now my question is: How can that be the case? Isn't EqV part of EV? How can an asset be of value to Equity holders, but not to Equity and Non-Equity holders jointly?

2) When determining EV, we are either subtracting operating liabilities from operating assets so as to arrive at net operating assets (asset-side approach) or we are summing up all Equity and Non-Equity claims, leaving out operating (i.e. non interest-bearing) liabilities (financing-side approach).
-> Now my question is: Why are operating liabilities not considered to be of value? Isn't this just another (interest-free) source of financing, whose funds generate cash flows and thereby value?

Many thanks in advance!

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Comments (4)

Jul 23, 2011

Enterprise Value does not include cash and other non-operating assets. Remember EV is:

Equity Value + Debt - Cash (non-operating assets)

The reason for this is that cash is liquid and non-operating so you wouldn't use it in valuing the firm on a EV basis (the cash would basically just net down the purchase cost, right?). You wouldn't buy cash for cash, right? So you make sure to take that out.

Equity Value is showing you what the value of the firm is to the shareholder, so you'd want to include cash. If the firm were to dissolve, this cash could (theoretically) be paid out.

Think of EV is what you would have to pay for the company if you were going to buy it. You don't buy operating liabilities (accounts payable for the most part) since they aren't debt liabilities and they don't add value unless it's on a net interest margin-basis (like a bank).

Does that help?

Jul 23, 2011

As to questions 1 -

When you go from Enterprise value to Equity Value you subtract Net Debt. Therefore, if a company has a large amount of what you call "non-operating assets" or what it is easier to call CASH, and a small amount of debt, then the company's Equity value can indeed be higher than its enterprise value. For example, APPL has like $70b in cash and no debt, so it has negative net debt and so it EqV is much higher than its enterprise value.

Cash on the left side of the balance sheet could be at any time used to reduce the value of the right hand of the balance sheet, through debt paydown, dividends, stock buybacks, whatever. Therefore, it is a negative when calculating the value of the financial structure of a firm.

Answer to number 2:

-Enterprise value is basically calculating how much you would have to pay to buy out all of the existing capital structure of a firm. Operating liabilities are not considered part of the financial structure of the firm. They are generated by operational decisions, not by financial decisions. For example, cash flows inventory will be ultimately decided by how good your inventory management is, not by how your business is capitalized. Your accounts receivable will be dictated by terms you decide with your suppliers, not with banks. Presumably, no matter what the capital structure, you will have the same amount of operating liabilities - they are independent of each other. Therefore, you do not include them in the enterprise value calculation.

Jul 24, 2011

Many thanks for your quick and extensive responses!

Two more thoughts/ questions on this:

  • Let's replace cash as an example for a non-operating asset with a real estate not used in operations. In this case, how can it be that this is of value for equity holders, but not to all stakeholders? If something is of value to equity holders, shouldn't it also be of value to equity and debt holders? Please get me right: I am not saying that this doesn't make sense - I am sure it's the right practice, but I am just searching for the correct theoretical explanation for it.
  • I understand the point that a buyer would not have to pay for operating liabilities in a real transaction. In theory, however, why do operating liabilities not add value? What if I were to replace my accounts payable with an interest-bearing revolver and pay suppliers right away. In that case, it would be counted for as "value", right? But where is the difference, except for the interest I pay on the revolver drawn?

Probably all of this is also connected with my basic skepticism towards the EV concept: I can't help, but I feel like price is confused with value. We talk about Enterprise Value, but in fact, we should say it's the Purchase Price, right? An example: If I were to sell a box worth 5 USD, with a 5 USD bill inside. What's the value of this box? It's 10 USD, isn't it? What's the effective Purchase Price? 5 USD (I pay 5 USD and get 5 USD, or the owner keeps it and sells it without the bill inside). And that's what we call EV. So, from my point of view, saying that something would not be paid for by a buyer in a transaction is not an explanation for excluding it in Enterprise Value.

What do you think about this? Am I missing something?

All the best and many thanks again.

Sep 23, 2017