What counts as "debt" in an enterprise value calculation?

hoodinternet's picture
Rank: Baboon | 124

I know every guide says "debt" is added to enterprise value, but what exactly comprises debt? Is it any long-term liability? Do short term notes count under this definition? Would a credit facility count as a "debt" in the EV calculation?

Enterprise Value Formula

Enterprise Value is a metric that attempts to reflect the market value of a firm. It attempts to provide a more accurate valuation that market capitalization when considering mergers and acquisitions. Whilst 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 Enterprise Value calculation is:

  • Market Capitalization + Debt + Minority Interest + Preferred Shares - Cash & Cash Equivalents

NYU Stern Corporate Finance Professor, Aswath Damodoran provides this handy, if a bit simplistic, diagram for calculating enterprise value. His post on different valuation metrics including enterprise value, firm value and market cap is worth a read.

Types of Debt

Debt is any money borrowed from a 3rd party that has to be paid back. But it's not that simple. There are different kinds of debt.

As @re-ib-ny, a Certified Private Equity Professional - Vice President shares:

There are two types of liabilities: operating and financial. Debt represents any financial liability, which would encompass both notes and credit facility obligations outstanding.

What distinguishes a financial liability from an operating liability? Ask yourself how the liability got on the balance sheet. If the company owes the liability to an entity who simply gave the company cash for the purpose of earning a return on investment, then the liability is financial (one simple test people use is to ask whether the liability earns a rate of return). If, however, the obligation got there in the course of doing business, then it is operating. So, for instance, accounts payable, accrued expenses, etc. (which are owed to suppliers and trade partners, not lenders seeking a rate of return) are all operating liabilities, not debt.

Short-term notes are essentially short-term bonds sold to investors; the company gets cash and the investors earn interest. Classic debt. Credit facilities are like credit cards for corporations. A bank (or syndicate of banks) will commit to giving a company cash, up to a limit, if requested. The company pays interest on the cash it borrows, as well as a fee on the undrawn amount as consideration for the banks making the capital available. Also classic debt.

Don't forget to include preferred equity and any other fixed obligation ranking senior to the common stock as debt in your enterprise value. Also, make sure to count options (less the proceeds received on exercise), restricted stock, restricted stock units, etc., when your are calculating equity value.

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Comments (109)

Aug 3, 2012

I think the most common types are: long term, short term, convertible and you can view preferred as a debt-like liability too.

Not sure about credit facility, you pay a certain fee for the corresponding size of the revolver, but I think one should include the amount drawn out of the credit facility as your debt as well. I think they normally are included in current debt portion.

Best Response
Aug 3, 2012

There are two types of liabilities: operating and financial. Debt represents any financial liability, which would encompass both notes and credit facility obligations outstanding.

What distinguishes a financial liability from an operating liability? Ask yourself how the liability got on the balance sheet. If the company owes the liability to an entity who simply gave the company cash for the purpose of earning a return on investment, then the liability is financial (one simple test people use is to ask whether the liability earns a rate of return). If, however, the obligation got there in the course of doing business, then it is operating. So, for instance, accounts payable, accrued expenses, etc. (which are owed to suppliers and trade partners, not lenders seeking a rate of return) are all operating liabilities, not debt.

Short-term notes are essentially short-term bonds sold to investors; the company gets cash and the investors earn interest. Classic debt. Credit facilities are like credit cards for corporations. A bank (or syndicate of banks) will commit to giving a company cash, up to a limit, if requested. The company pays interest on the cash it borrows, as well as a fee on the undrawn amount as consideration for the banks making the capital available. Also classic debt.

Don't forget to include preferred equity and any other fixed obligation ranking senior to the common stock as debt in your enterprise value. Also, make sure to count options (less the proceeds received on exercise), restricted stock, restricted stock units, etc., when your are calculating equity value.

    • 6
Sep 18, 2014

Why do I add restricted stock units? When I calculate with the fully diluted shares outstanding it is already implied, no? Or do I get this wrong?

Aug 3, 2012

The minimum requirement I apply pertaining to debt is whether it is interest-bearing or not.

As such, if the short term notes are interest bearing, then yes. Also, I would think that it depends on the credit facility and if it is exercised upon. Not too sure about the latter though!

Aug 4, 2012
thecoldburns:

The minimum requirement I apply pertaining to debt is whether it is interest-bearing or not.

As such, if the short term notes are interest bearing, then yes. Also, I would think that it depends on the credit facility and if it is exercised upon. Not too sure about the latter though!

This is correct. Interest-bearing = debt.

Aug 3, 2012

Do any of the professionals here add in operating leases like Damodaran does?

Aug 3, 2012
Cola Coca:

Do any of the professionals here add in operating leases like Damodaran does?

yes, and in addition to recourse securitized ARs

Aug 3, 2012
Oreos:
Cola Coca:

Do any of the professionals here add in operating leases like Damodaran does?

yes, and in addition to recourse securitized ARs

Thanks for the info.

No experience here, so I hadn't heard of recourse securitized ARs until now. Sounds somewhat dumb, but I guess it's no different than mortgage putbacks.

Aug 3, 2012
Oreos:
Cola Coca:

Do any of the professionals here add in operating leases like Damodaran does?

yes, and in addition to recourse securitized ARs

You can also add Pension and OPEB liabilities to total debt

Aug 3, 2012

I recommend this book for all finance questions:
http://www.scoopbooks.com/

Aug 3, 2012

Thanks a lot guys. I'm quickly realizing that all the "simple" concepts I learned about in class and finance tutorials on the web get a lot messier when you are actually looking at balance sheets and wondering what half the items mean haha.

Aug 4, 2012

good points up there.

i do want to add tho that some of the times those debt are only debt if you are looking at the equity. There will be different priorities/guarantees to them so when you look at different credit investing opportunities, they will be different analyses.

Also in other industries such as glass packaging, you usually have the asbestos liability, which was created due to legal going-concern problems. I am sure some companies also have this unique line item as well

Aug 4, 2012
Ricqles:

Also in other industries such as glass packaging, you usually have the asbestos liability, which was created due to legal going-concern problems.

Nice lingo

Aug 15, 2012

Don't forget about the effects of underfunded pensions and ongoing leases...!

Sep 18, 2014

Strong bump with completely unrelated question

Sep 18, 2014

Sometimes analysts will adjust Enterprise value to include accounts receivables (depends on liquidity, and yes there are people who buy accounts receivables for cash), and I am sure if there was a significant amount of Accounts payable (something that would have a material difference in the value) it would be adjusted for as well. Otherwise, equity value + net debt + minority interest + preferred stock is used as an easy way to see (as you mentioned) how much should be paid for the firm.

In the real world, analysts will use public comps, acquisition comps, dcf, and lbo to get values, and then accretion/dilution analysis to see the impact of a merger on the new company. For the two comp sets, Enterprise Value is a quick and useful tool to get your multiples. For the DCF and LBO, accounts payable would be incorporated in your Free Cash Flow calculation and ultimately into your enterprise value. Finally, accretion/dilution will show you the full blown effect of the accounts payable on the new company's EPS. Theoretically, it should be included but the function of Enterprise Value is to provide a quick and easy answer.

Hope this helps, maybe someone will come along and confirm it or rip it to shreds.

Sep 18, 2014

think zip is pretty spot on here. first of all yes to be completely accurate yes A/R and AP would be included but most companies have 30-90 day periods so outstanding AR and AP will be gone by the time the acquisition is consumated. also, for many of the companies i look at, there are significant legacy liabilities (pension, OPEB, environmental) which generally rank pari with unsecured debt and are added in the enterprise value calculation.

secondly, yes analysts typically use what is known as a "football field", combining comps acq compds, dcf, multiples etc.

Sep 18, 2014

Thanks. That helps.

Sep 18, 2014

"so enterprise value is the minimum amount you should pay for a firm" -- why do you think so?

Best,
SoulSearching

Best,
SoulSearching

Sep 18, 2014

I'm no expert but wouldn't things like ap be factored into the equity value?

Sep 18, 2014

Isn't the point of enterprise value to find the purchase price of the company's core operations if you were to retire the debt? In that case I don't think AR and AP would be included. Say you had two companies - exactly the same - except one had $100 million more in A/R. I would think their market cap would be roughly $100 million more. The same is true with debt, but I think you are looking at what the company would look like without that debt. I'm just a summer so please correct me where I'm wrong.

Sep 18, 2014

equity value is an open-ended call option on the Enterprise Value of the firm.

Sep 18, 2014
John Mack:

equity value is an open-ended call option on the Enterprise Value of the firm.

that's BS

Sep 18, 2014

...no it's not.

But perhaps you'd like to enlighten us as to why you think it is?

Sep 18, 2014

equity value = stock price (* no of shares outstanding), and the stock of the company is not a call option on the enterprise value of this very company. This is absolute BS.
Besides, buying the stock, you pay its full price (rather than an option premium).
Then, if we for a minute imagine your statement were true, we would need to have accepted that enterprise value may be considered an underlying (on which an option is written). This is not that easy - on the contrary to the equity value (or MCap), EV is not as clearly defined (so that in different cases, some portions of liabilities may or may not be considered parts of net debt, for example).
Then, with options, buyer doesn't have any obligations (only rights - after he has paid the premium), while writer has only obligations, but no rigghts (after he has received the premium). With stock, it is not so: buyer of the stock (i.e. shareholder) has both righths and obligations.

And so on, and so forth - i.e. your statement is absolute BS.

Sep 18, 2014

Typically working capital will need to be maintained within a certain range up to the close of the transaction. This is to keep a seller from selling off all their inventory and collecting all accounts receivable while holding off on paying any bills.

Most of the deals I have seen (which doesn't amount to too many), the buyer will give a range that working capital will need to be within at the time documents are signed and funds flow. If working capital falls out of this range, adjustments are made at close.

Hope this helps.

Sep 18, 2014
Ivan:

equity value = stock price (* no of shares outstanding),

That is true and, yet, is in no way incongruous with my statement.

Ivan:

and the stock of the company is not a call option on the enterprise value of this very company. This is absolute BS.

Just because you say it doesn't make it true.

Ivan:

Besides, buying the stock, you pay its full price (rather than an option premium).

Consider the share price as the premium itself. If the Enterprise value goes up and the debt stays the same then you can sell these "call option" onto someone else. Alternatively, if the company goes bust then your "options" (shares) become worthless. But you never lose more than your premium - just like a call option.

Ivan:

Then, if we for a minute imagine your statement were true, we would need to have accepted that enterprise value may be considered an underlying (on which an option is written). This is not that easy -

Why not? Is there any other asset in the world that you would buy without giving consideration to the total amount that you have to pay to acquire that asset. When you buy a house, do you ignore the fact that there's a million dollar price tag on a hovel in Detroit because you only have to put $100 down? Or would you pay $1000 for a can of coke because you can pay 2 cents now and finance the rest? Didn't think so.

Ivan:

on the contrary to the equity value (or MCap), EV is not as clearly defined (so that in different cases, some portions of liabilities may or may not be considered parts of net debt, for example).

On the contrary, it's very simple - EV is the value of the firm. Whether you want to base that on the market-implied calculation, or a peer comparison is up to you. But that's what it is.

Ivan:

Then, with options, buyer doesn't have any obligations (only rights - after he has paid the premium),

Like a shareholder - who doesn't have any obligations beyond the "premium" that has been paid for the shares.

Ivan:

while writer has only obligations, but no rigghts (after he has received the premium).

Like a short-seller of stock. If you trace it back to the root (the primary equity issuance), the company has foregone part of its future upside to its own enterprise value in order to get some guaranteed money up front.

Ivan:

With stock, it is not so: buyer of the stock (i.e. shareholder) has both righths and obligations.

Maybe I have been remiss in my duties as a shareholder. What obligations do I have other than what it cost me to buy the shares ("premium")

Ivan:

And so on, and so forth - i.e. your statement is absolute BS.

Get back to me when you've thought things through a bit rather than automatically dismissing anything that doesn't exactly match what you were taught in school.

Sep 18, 2014
John Mack:

Get back to me when you've thought things through a bit rather than automatically dismissing anything that doesn't exactly match what you were taught in school.

Like it or not, but eqiuty value is "the value" which has ultimate importance, not EV. If you were talking about ways in which we could consider the EV a call option on the equity value, it might have been another story. It would have even made sense: via maximizing the value of the business we try to achieve the main task - i.e. maximize the value of the firm for its shareholders. Actually, that's what is being done in reality: people employ various business models, use leverage when it is economically efficient, undertake M&A transactions etc - all in order to increase the value of equity. But vice verca, in your interpretation, it doesn't make economic sense, in my opinion.

Also, I would ask that you change your tone: I am not a student who's a "banker wannabe" and have rather decent track record. Whether or not you have enough under your belt to talk to me in such tone, I am not sure.

Sep 18, 2014

the funn thing is that you have not set forth any argument, you've wrote a statement.

When an investor buys 100 shares in the company, he pays for equity value, not for EV. and when time to sell comes, the return of this shareholder will again be determined by its equity value. Definitely, this investor considers financial, as well as all other factors, but all these factors are already accounted for by the market and are thus in the stock price (of course market is not 100% efficient, but at least on developped markets with high liquidity it is significantly efficient).

What is more, when hedge funds \ institutional investors influence the momentum of the share price by buying\selling large volumes (sometimes even manipulating the market) - they again do not care about EV, as profits from trading operations arise from differences in stock prices, not EV.
Actually, for any financial investor equity value is the ultimate figure. For strategic investor entering M&A transaction it might be somewhat different - as this investor may wish to gain a certain level of control over acquired assets, so that to (possibly) influence management decisions (like, for example, usage of leverage).

With regards to buying a house: there are 2 main options - to buy a house with 100% cash payment or with a mixture of cash and debt. Which one to choose depends on market conditions and personal preferences\circumstances. And regardless of what one chooses, finally, upon disposal, he will care about net gain of the operation, which will be represented by the change of one's net worth (total amount of money he receives minus total amount of money he has paid, after making all required debt repayments and such).

Sep 18, 2014

there's a lot of noise (read: garbage) in many of the above posts. Enterprise Value reflects the fair market value of the OPERATIONS of the firm attributed to ALL providers of capital. Shareholders are one type of providers of capital and therefore equity value (market cap) is one component of enterprise value. whether one looks at enterprise value or equity value depends on one's purpose. having said that, even if you want equity value (e.g. you are an equity research analyst or investor in stocks) it is always better to value the equity by first valuing the enterprise (then subtracting debt, etc.) rather than by valuing the equity directly. the debt in the EV formula only includes interest bearing debt and does not include accounts payable or other operating liabilities.

enterprise value is NOT the minimum amount one pays for a firm.

Sep 18, 2014

Ivan,
Whether I agree or disagree with what you wrote in your last comment is irrelevant as it has says nothing that questions my original assertion:

"equity value is an open-ended call option on the Enterprise Value of the firm"

Now, with the exception of it being open-ended (and hence why I included this important point within my definition), please explain to me what characteristic of equity is incongruous with a call option?

You have also outdone yourself with your comment about "investors not caring about EV". Up until that point, I just thought that you were misunderstanding what I have written but now I am seriously worried for the people that you "advise".

And finally, just to be clear on what you wrote in your final paragraph. Can you confirm that you are saying that you would give no consideration to actual price of the house when deciding whether to buy, only how you would finance it? Because that is how it reads. And if the answer is "no", then what you are saying is that you agree with me - once you get your head around it.

Sep 18, 2014
John Mack:

Ivan,
Can you confirm that you are saying that you would give no consideration to actual price of the house when deciding whether to buy, only how you would finance it?

No. You suggested that we take purchase of a house as an example - so writing above, I assumed that the decision to buy has already been taken (i.e. various factors like location, condition, price and many others were already considered beforehand). Definitely, all these things are important.

Sep 18, 2014

John Mack is correct.

Nb: It is not a used valuation technique in practice. However, one with a general education in finance should have seen this concept of valuation of equity using an option perspective.

Here's a quick link I found online for some intuition:
http://pages.stern.nyu.edu/~adamodar/New_Home_Page...

Sep 18, 2014

While equity can be viewed as a call option, I think the original statement is slightly off. Equity is a call option on the assets (with debt being the strike price) not the enterprise value.

Sep 18, 2014

my dick is huge, highly levered. so don't talk to me in a negative tone either.... just throwing that out there

Sep 18, 2014

Even if the company is a going concern, equity is not a call option for all future profits. Equity holders will only get the portion of the profits after debt holders get paid (interest).

Sep 18, 2014

John Mack's spot on.

Ivan - It's better to keep your mouth closed and let people think you are an idiot, than open it and remove all doubt - Mark Twain

Sep 18, 2014

but John Mack has made a well-reasoned argument here.

Sep 18, 2014

What is funny, is that Mack says equty value (i.e. stocks) is a call option, while call option is a derivative financial instrument. One of the distinguishing features of any derivate fnancial instrument is that it is NOT a valuable security. stocks, on the contrary, are valuable securities by definition, and as such, they may not be considered a derivative instrument (though, of course, they may be an underlying to a call option).

Sep 18, 2014
Ivan:

What is funny, is that Mack says equty value (i.e. stocks) is a call option, while call option is a derivative financial instrument. One of the distinguishing features of any derivate fnancial instrument is that it is NOT a valuable security. stocks, on the contrary, are valuable securities by definition, and as such, they may not be considered a derivative instrument (though, of course, they may be an underlying to a call option).

That's not funny. Nor is it relevant.

Sep 18, 2014

He could not be more vague with his statements, and simply asks questions or disagrees without giving any substantial argument.

Sep 18, 2014

you get the cash, but also the obligation to pay that cash back in the future including interest payments. The intrinsic value of your shares will only rise if you can use that cash for activities that yield a higher return than the yield on your debt.

    • 1
Sep 18, 2014

Just look at your formula. If you are saying Market Cap includes cash in some way, then, based off your formula, EV - Debt + Cash = Market Cap. If you raise $100 in cash from debt, then debt goes up by $100 and cash goes up by $100. If you plug that into your formula, you get a net effect of $0 because - $100 debt + $100 cash = 0.

Now this is going in deeper, but your EV does change when you issue more debt because higher debt increases interest expense, lowering free cash flow, and increases debt/cap and changes your discount rate (WACC). So, market cap actually does change when you raise cash from debt, but not in the way you're thinking of it.

Sep 18, 2014

thank you guys- much appreciated.

Sep 18, 2014

Debt doesn't add value to a business (outside use as a tax shield - but this doesn't increase the value of the operations)

Sep 18, 2014

why is it included in enterprise value?

Sep 18, 2014

You aren't thinking about this properly. Think about business value in terms of assets. Assets and the income/cash flow that they generate are funded by debt and equity.

If A = L + SE, EV measures the total value of the business b/c that value is derived from the assets and their cash flow/income generation ability.

    • 2
Sep 18, 2014
peinvestor2012:

You aren't thinking about this properly. Think about business value in terms of assets. Assets and the income/cash flow that they generate are funded by debt and equity.

If A = L + SE, EV measures the total value of the business b/c that value is derived from the assets and their cash flow/income generation ability.

Nice explanation man, I think I flamed you earlier for some shit you were posting, but you've definirely been posting up some good shit lately. My apologies and +1.

'Before you enter... be willing to pay the price'

Sep 18, 2014

thank you, that helps

Sep 18, 2014
anacott steal:

thank you, that helps

NP. Once you get into the field things will become much easier to understand from that aspect. I thought the same way years back.

Sep 18, 2014

Think of it this way:

You buy a house for $1M cash, it's worth $1M
$500k cash / $500k debt, it's worth $1M
$0 cash, $1M debt, still worth $1M

Hence, total value = equity value + debt amount

Simplified, but I think you get the idea...

    • 1
Sep 18, 2014

In debt for equity substitutions you increase firm value through the tax shield. I'm not positive but I believe EV would be increased by $25*Tax rate.

Take that with a grain of salt. But intuitively when you substitute debt for equity you end up with high net income so you would expect most measures of firm value would increase.

Sep 18, 2014

^I believe because you raised $25 in debt, your EV goes up by 25. But the equity value of the firm goes up by 25*tax rate

Sep 18, 2014

Interested in hearing a thorough response.

Sep 18, 2014

Well, let's break this down...
Initial equity value: 50
Initial Debt: 50
Initial EV: 100

Subsequent Equity Value: 50 + 25*tax rate (tax shield) - 25 (repurchase)
Subsequent Debt: 50 + 25
Subsequent EV: 50 + (25*tax rate) - 25 + 50 + 25

To answer your question directly, no, the EV would not be the same.

Hope this helps.

The difference between successful people and others is largely a habit - a controlled habit of doing every task better, faster and more efficiently.

    • 1
Sep 18, 2014
mhurricane:

Subsequent equity value: 50 + 25*tax rate (tax shield) - 25 (repurchase)
.

Could you explain this part?

Sep 18, 2014

One would assume that you're taking into account the fact that you'd have to pay back the creditors eventually.

Sep 18, 2014

A lot of bonds have covenants that include a change in control provision (i.e. the debtor has to repay the debt prior to maturity in case of a change in control, otherwise it'd count as a technical default)

Sep 18, 2014

The enterprise value doesn't have to equal the actual proceeds delivered to the target. Let's assume an all cash deal where you acquire 100% of XYZ and you leave the company leveraged as is. So let's assume:

XYZ:
equity value: $100m
Debt: $20m
Excess cash: $0
Enterprise value: $120m

The amount acquirer pays the target is only $100m. However, you are getting a company worth $120m. How is it possible to get a company worth $120m for $100m? Simple, you the acquirer have also assumed the $20m in debt. You effectively had two pay $120 because of the debt you assumed. That's why EV should be used regardless of whether you in actuality assume the liabilities or not.

Matan Feldman
Founder, Wall Street Prep
Learn Financial Modeling

Sep 18, 2014

@matanf: I am almost there but not quite, lol.

As the acquirer, why would you really even care about the debt? You only care about the equity value, cause at the end of the day that is what your profit is going to be based on.

Also, you said that XYZ is "worth" $120m. Well, I would say that since the acquirer owns the equity, it's really only worth $100m.

Sep 18, 2014

Also, you said that XYZ is "worth" $120m. Well, I would say that since the acquirer owns the equity, it's really only worth $100m.

Correct if you're talking about the equity - the equity is worth $100m - but the business as a whole is worth $120. The point is, enterprise value represents the value of the business regardless of how it is capitalized. Yo could choose to buy out the lenders, in which case you'd have to pay $120. You could choose to leave them in tact (assuming you're contractually allowed to) and then you'd only have to pay $100 (but they would have a priority claim against the business in front of you). You could also choose to lever it up even further and put in even less equity, but ultimately, the value of the business doesn't change (more or less) - what changes is the capital structure (the debt/equity).

Think of it this way - You want to buy a house that's selling for $1m, which you could finance with $200k of your own money, the rest with debt - obviously you care about debt in the sense that whatever the value of the house ($1m), the value to you (the equity owner), equals the value of the house less the debt outstanding. While the value of the house is $1m, the cash you spend is $200k. You could have chosen instead to finance it with $700k of your own money - it wouldn't change the value of the house, just the capital structure.

Matan Feldman
Founder, Wall Street Prep
Learn Financial Modeling

Sep 18, 2014

You add back debt in order to assess the value of the business in its entirety, notwithstanding how the business was financed (i.e. its capital structure). Think the mortgage / house example referenced above is a perfect analogy; to assess the worth or value of a house, you would not only look at what you contributed directly, independent of what a bank has loaned you. Instead, you would look at the sum of all capital employed which should equate to the value of the asset.

Sep 18, 2014

I was under the impression that you add back debt when calculating Enterprise Value because any takeover of the company must involve all current debt being paid off

Sep 18, 2014

@ElliotWaveSurfer

although that may certainly happen, it really has nothing to do with why enterprise value is a valuation metric. Its quite possible that pre-deal debt is reinstated and you would still want to look at valuation using enterprise value for the reasons i described above. The enterprise value is a way to analyze value independent of the capital structure. Getting back to the house example - if i want to buy the house from someone else, i want to look at enterprise value regardless of whether i assume the sellers mortgage (obviously unlikely in a house example) or whether i take on a new mortgage. what matters to me is the value of the house regardless of the seller's capital structure. Just to be clear, the seller's capital structure does matter in the sense that it tells me who i have to pay (the seller, the seller's lenders, or new lenders) but enterprise value identifies the actual value of the business im buying.

Matan Feldman
Founder, Wall Street Prep
Learn Financial Modeling

Sep 18, 2014

Update: When subtracting debt, include all debt numbers. Short term, long term, mezz etc.

Still researching conv red pref stock, but assuming that would be included in the calculation.

Sep 18, 2014

C-R-A, M-001 is not backwards. He's trying to get from EV to equity value.

Your equation is more or less correct, and the convertibles should count as preferreds.

Sep 18, 2014

noway, thank you for the confirmation.

  • eyelikecheese
  •  Sep 18, 2014

^^^^^ Wow thats some good product placement/advertising

Sep 18, 2014

1) no, otherwise you'd be double counting cash.
2) simplistically, you buy company, company has (excess) cash, you pay yourself that cash or pay down debt, your net EV has decreased. all cash is used, rather than excess, because calculating excess is subjective, all cash makes comps more compy. if it's a liquid non-operating asset (e.g. excess cash) it can be easily sold to reduce the EV (so once you buy the company, you sell X to give you cash to offset your purchase price, it's not instantaneous, but is assumed to be)

Sep 18, 2014
Oreos:

if it's a liquid non-operating asset (e.g. excess cash) it can be easily sold to reduce the EV

One caveat - if cash is held as an operating asset (i.e. minimum cash), then its value should be incorporated in the derived equity value as opposed to excess cash.

Sep 18, 2014

Thanks, Oreos. In relation to comment 2), it seems you are saying the non-operating asset should be deducted from EV as well? Shouldn't it be added?

So in the case of a textile manufacturer, if it has a non-operating asset (e.g. a farm), would you add this to EV or would you deduct from EV assuming you would be able to convert it to cash and use the cash to reduce EV?

Thanks.

Sep 18, 2014

Thanks all for their comments. However, I am getting slightly confused by the replies so I think I really need a clear understanding of the fundamental principles of valuation. I would really appreciate it if you could confirm these for me.

The use of a scenario would makes things clearer, let's assume:

Business A has:
a) DCF of operating cashflows - 10m
b) Total debt - 5m
c) Operating cash - 1m
d) Excess cash - 3m
e) Real estate (non-operating asset) - 5m

Total value of Business A

The total value of Business A includes the present value of its operating cashflows, plus the value of any non-operating assets.

DCF of operating cashflow 10m
Add: Excess cash 3m
Add: Real estate 5m
Total value 18m

Enterprise value of Business A

The EV represents the cost to acquire this business. Since non-operating assets could be converted to cash and used to reduce the purchase price, the value of non-operating assets is deducted from the DCF of operating cashflow to obtain the enterprise value.

DCF of operating cashflow 10m
Less: Excess cash -3m
Less: Real estate -5m
Total Enterprise value 2m

equity value of Business A

Equity value represents the claim of the equity holder on the business, therefore the value of the net debt is deducted, but the value of non-operating assets included.

DCF of operating cashflow 10m
Less: Net debt -4m (5m-1m)
Add: Excess cash 3m
Add: Real estate 5m
Total Equity value 14m

I would really appreciate it if you could clear up these concepts for me. Thanks!

Sep 18, 2014

Isnt the formula above missing Preferred Stock (source: BIWS)?

Sep 18, 2014
hopesanddreams:

Isnt the formula above missing Preferred Stock (source: BIWS)?

This is a more general formula for EV. EV = stuff you have to refi or buy off someone (STYHTROBOS) + stuff you cant afford to pay off using operating cash flow (SYCATPOUOCF) - stuff which decreases your purchase price (SWDYPP).

STYHTROBOS = eg, debt, pref stock, equity some financial leases and maybe some operating leases depending on how thorough you want to be

SYCATPOUOCF = eg, pension liabilities, contingent liabilities, large movements in working capital, imperative capex etc....

SWDYPP = cash, investments in financial assets (if not a bank), liquid non-operating assets

Sep 18, 2014

Hi all, just wondering whether anyone could confirm my understanding of the three concepts (please refer to my post) are correct? Thank you so much!

Sep 18, 2014

Um... I think you're confused.

Steps to a DCF (free cash flow to the firm)
1. Project 3-10 yrs of Free Cash Flows (standard is 5)
2. Arrive at Terminal Value (use either gordon growth or exit multiple method)
3. Discount FCF and TV back to present at WACC --> gives you your Enterprise Value
4. Move from Enterprise Value to equity value using the equation:
Enterprise Value = Equity Value + Net Debt (debt-cash) + Minority Int + Pref Stock + other unfunded liabilities
5. Divide equity value by diluted shares outstanding

You discount everything back to the present before you move from Enterprise to Equity value. Therefore you use today's cash balance (and debt/minority int/etc) balance

Hope this helps.

"Success means having the courage, the determination, and the will to become the person you believe you were meant to be"

Sep 18, 2014
nontargetPSD92:

Um... I think you're confused.

Steps to a DCF (free cash flow to the firm)

1. Project 3-10 yrs of Free Cash Flows (standard is 5)

2. Arrive at Terminal Value (use either gordon growth or exit multiple method)

3. Discount FCF and TV back to present at WACC --> gives you your Enterprise Value

4. Move from Enterprise Value to equity value using the equation:

Enterprise Value = Equity Value + Net Debt (debt-cash) + Minority Int + Pref Stock + other unfunded liabilities

5. Divide equity value by diluted shares outstanding

You discount everything back to the present before you move from Enterprise to Equity value. Therefore you use today's cash balance (and debt/minority int/etc) balance

Hope this helps.

Thanks for explaining this. So when you add Net Debt, should it be current net debt or the projected net debt?

Sep 18, 2014

also, its "sheds light on". not "shades light on"
FYI...

"Success means having the courage, the determination, and the will to become the person you believe you were meant to be"

Sep 18, 2014
nontargetPSD92:

also, its "sheds light on". not "shades light on"

FYI...

lmao that's why I don't get interviews...sorry I am not a native speaker, and thanks for pointing this out without making a fuzz :D

Sep 18, 2014

I think he means add cash when calculating equity value once EV is determined after you add together the PV of both the projected FCF and the TV...

"An investment in knowledge pays the best interest." - Benjamin Franklin

Sep 18, 2014
StudentLoanBackedSecurities:

I think he means add cash when calculating equity value once EV is determined after you add together the PV of both the projected FCF and the TV...

Yeap you sir got me right. I mean once I multiplied my terminal year whatever (i.e. EBITDA) by some multiple and discounted it back to today, I got a discounted terminal year EV. No to get to the equity part, I think I should add projected cahs balance not the current one. However, I have seen people adding current balance...

Sep 18, 2014
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Sep 18, 2014
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