Enterprise Value (EV)
What is Enterprise Value?
Enterprise value is one of the most common types of company valuation used in corporate finance, along with equity value. Enterprise value is the value of the operational business, independent of capital structure. Equity value (or market capitalization) is the value attributable to the owners or shareholders (frequently expressed on a per-share basis for public companies).
For valuation purposes, enterprise value focuses on the operations of the company and is unaffected by financing decisions (unlike equity value). When considering what drives its value, this includes company performance, industry dynamics and general economic factors. The distinction between enterprise value and equity value is important for analysts who want to ignore the impacts of capital structure. A company looking to acquire a target company is likely to be more interested in the sales, cost structure and products it sells. This is because companies looking to value and acquire a target can change the capital structure (how the company is financed) with ownership.
Key Learning Points
- Enterprise value is the value of the operational business and is unaffected by capital structure changes (except at high leverage levels where the level of debt confers extra risk as the default probability rises)
- It is driven by a combination of factors including company performance, industry dynamics and economic climates
- The EV to equity bridge is summarized as enterprise value = equity value + debt – cash and cash equivalents
- The enterprise value of a company should always be compared with comparable companies to provide meaningful outcomes i.e. operate in similar industries, similar depreciation policies
Calculating the Enterprise Value
In order to find the enterprise value we can expand and rearrange the accounting equation:
Assets = Liabilities + Equity
Since enterprise value is the fair value of the net operational assets, the equation can be expanded to identify these components as follows:
Operating Assets + Cash = Operating Liabilities + Debt + Equity
If the equation is rearranged, the operating components can be isolated:
Operating Assets – Operating Liabilities = Debt + Equity – Cash
Balance sheet amounts are book value or carrying value but for valuation, all components must be at the market or fair value. We assume that cash is excess cash and part of the capital structure. Debt less cash is known as net debt.
Enterprise to Equity Value Bridge
Since enterprise value equals net debt plus equity, the enterprise value can be derived from the equity value and vice versa. In addition, non-core assets, non-controlling interest (NCI) and debt equivalents can be included for a more detailed Enterprise to Equity Value Bridge. The additional elements are described below. This visual representation summarises the balance best:
Net debt is calculated as interest-bearing liabilities less highly liquid financial assets. Often this can be simplified to total debt (current and non-current) less cash and cash equivalents.
Non-core assets are assets that are not considered necessary to a business’s core operation or are no longer used. This typically includes minority stakes the company holds in other companies, which are sometimes called affiliates or equity method investments. Removing them ensures the EV stays focused on the core operations of the company.
Debt equivalents include any liability which could, through an event, be converted into debt. This includes debt-like claims which are difficult to value. These may require significant judgement and expertise. An example is a pension deficit for a defined benefit pension scheme.
Non-controlling interest (NCI), also called minority interest is the portion of a subsidiary company that is not owned by the parent company. This is typically less than 50% because if the portion is greater than 50%, the parent company usually ceases to be the controlling entity, and the company in question would no longer be a subsidiary of the parent.
Equity represents the shareholders initial investment and any excess value (profits) created by the company once its other claims such as debt have been paid off. Although equity is available on the balance sheet it’s not a very accurate view of the value due to accounting rules. If we used the book value of equity we’d usually be undervaluing the equity, and so the EV, drastically. A better starting point would be the share price working towards market capitalization.
A visual interpretation and a worked example of how to get from Equity Value to Enterprise Value and vice versa are shown below:
Access the free download to test your understanding and practice calculating enterprise value.
Limitations of Using Enterprise Value
Although EV is widely used in valuation, and has many strengths it’s not always useful. Some organizations have operations and finance so tightly linked that trying to separate them isn’t useful. For example, banks could be said to ‘trade’ in loans and deposits. This means EV is not used when valuing banks and other financial organizations.