Enterprise Value vs Equity Value – This is one of the most common valuation topics that causes confusion in Equity Research and Investment Banking. In most basic terms, Equity Value is the value only to the shareholders, however, Enterprise value is the value of the firm that accrues to both the shareholders and the debt holders (combined). In this article, we try and demystify the key comparisons between Enterprise Value vs Equity Value.
Below are the topics covered in this article
What is Equity Value?
Equity Value is simply the Value of a firm’s equity i.e. the market Capitalization of the Firm. It can be calculated by multiplying the market value per share by the total number of shares outstanding.
For example, let’s assume Company A has the following characteristics:
Based on the formula above, you can calculate Company A’s Equity value as follows:
$1,000,000 x 50 = $50,000,000
However, in most cases this is not an accurate reflection of a company’s true value.
What is Enterprise Value?
Enterprise value considers much more than just the value of a company’s outstanding equity. It tells you how much a business is worth. Enterprise value is the theoretical price an acquirer might pay for another firm, and is useful in comparing firms with different capital structures since the value of a firm is unaffected by its choice of capital structure. To buy a company outright, an acquirer would have to assume the acquired company’s debt, though it would also receive all of the acquired company’s cash. Acquiring the debt increases the cost to buy the company, but acquiring the cash reduces the cost of acquiring the company.
- Enterprise Value = Market value of operating assets
- Equity Value = Market value of shareholders’ equity
Net Debt – Net debt is equal to total debt less cash and cash equivalents.- When calculating total debt, be sure you include both the long-term debt and the current portion of long-term debt, or short-term debt. Any in-the-money (ITM) convertible debt is treated as if converted to equity and is not considered debt.
- When calculating cash and equivalents, you should include such balance sheet items as Available for Sale Securities and Marketable Securities,
- The market value of debt should be used in the calculation of enterprise value. However, in practice you can usually use the book value of the debt.
Let me explain it with an example. Consider the same company A and an another company B having the same market capitalization. We assume two scenarios, 1 and 2.
Calculate Enterprise Value for Scenario 1.
Enterprise Value for Company A is Market Capitalization ($50 million) + Debt ($20 million) – Cash and Short term investments ($0) = $70 million. EV for Company B is Market Capitalization ($50 million) + Debt ($0) – Cash and Short term investments ($0) = $50 million.
While both companies have the same market capitalization, the better buy is Company B, or the company with no debt.
Now, consider scenario 2
Calculate Enterprise Value for Scenario 2. EV for Company A is Market Capitalization ($50 million) + Debt ($0) – Cash and Short term investments ($5 million) = $45 million. EV for Company B is Market Capitalization ($50 million) + Debt ($0) – Cash and Short term investments ($15 million) = $35 million.
While both companies have the same market capitalization and no debt, the better deal is Company B as you would assume $15 million in cash upon purchase of the company.
Equity Value vs Enterprise Value
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Equity Value vs Enterprise Value Multiples
What is Equity Value Multiple?
The equity value multiples have both the numerator and the denominator as “Equity” measure. Some of the multiples of Equity value multiples are as per below.
Numerator – Equity Value is Price per share that shareholder’s are expected to pay for a single share of the company under consideration
Denominator – Operating parameters like EPS, CFS, BV etc equity measures. For example EPS – Earnings per share and it reflects the profit per share that accrues to the shareholders.
- PE Multiple – This ‘headline’ ratio is in essence a payback calculation: it states how many years’ earnings it will take for the investor to recover the price paid for the shares. Other things being equal, when comparing the price of two stocks in the same sector the investor should prefer the one with the lowest PE.
- PCF Multiple – It is a measure of the market’s expectations of a firm’s future financial health. This measure deals with cash flow, the effects of depreciation and other non-cash factors are removed.
- P/BV Multiple – Useful measure where tangible assets are the source of value generation. Because of its close linkage to return on equity (price to book is PE multiplied by ROE), it is useful to view price to book value together with ROE
- P/S Multiple – Price/sales can be useful when a company is loss making or its margins are uncharacteristically low (distressed firms)
- PEG Multiple – A ratio used to determine stock’s value while taking into account earnings growth. The enterprise value multiples have both the numerator and the denominator as “Pre Debt” and “Pre-Equity” measure. Some of the multiples of Enterprise value multiples are as per below.
What is Enterprise Value Multiples?
Numerator – Enterprise Value is primarily a pre-debt and pre-equity measure as EV reflects values both to the Debtors as well as Shareholders’.
Denominator – Operating parameters like Sales, EBITDA, EBIT, FCF, Capacity are pre-debt and pre-equity measures. For example EBITDA – Earnings “before” Interest tax depreciation and amortization; this implies that EBITDA is measure before the debtors and shareholders are paid off and likewise.
- EV/EBITDA Multiple – Measure that indicates the value of the overall company, not just equity. EV / EBITDA, is a measure of the cost of a stock which is more frequently valid for comparisons across companies than the price to earnings ratio. Like the P/E ratio, the EV / EBITDA ratio is a measure of how expensive a stock is.
- EV/Sales Multiple – EV/sales is a crude measure, but least susceptible to accounting differences. It is equivalent to its equity counterpart, price to sales, where company has no debt
- EV/EBIT Multiple – EBIT is a better measure of ‘free’ (post-maintenance capital spending) cash flow than EBITDA and is more comparable where capital intensities differ.
- EV/FCF Multiple – EV/FCF is preferable to EV/EBITDA for comparing companies within a sector. Comparing across sectors or markets where companies have widely varying degrees of capital intensity
- EV/Capacity – Core EV/units of capacity (such as tonnes of cement capacity) or another revenue-generating unit (such as subscribers).
How to determine if the company Overvalued or Undervalued?
There are primarily two ways in which fair valuation of the company can be arrived at using Relative Valuation technique. They are Historical Multiple Method and Sector Multiple Method.
Historical Multiple Method
The common approach is to compare the current multiple to a historical multiple measured at a comparable point in the business cycle and macroeconomic environment.
The interpretations are relatively simpler if we create the Price to Earnings Graph. As noted above, the Foodland Farsi current PE ~ 20x, however, the historical average PE was closer to 8.6x.
Currently, the market is commanding $20/EPS (defined as PE); however, in the past this stock was trading at $8.6/EPS. This implies that the stock is overvalued with PE = 20x, when compared with historical PE = 8.6x and we may recommend SELL position on this stock.
Sector Multiple Method
In this approach we compare current multiples to those of other companies, a sector or a market. Below is a hypothetical example to explain this methodology.
From the table above, the average PE multiple for IT sector is 20.7x. However, the company under consideration – Infosys is trading at 17.0x. This implies that Infosys is trading below the average sector multiple and a BUY signal is warranted.
Comparable Company Analysis
Below is a typical relative valuation table that an analyst is expected to produce as a part of research. The comparison table contains the sector companies and their respective operating and valuation parameters. In most cases, the parameters contained in the table are as per below
- Company Name
- Latest Price
- Market Capitalization
- Enterprise Value
- EBITDA
- Net Income
- Valuation Methodologies like PE, EV/EBTIDA, P/CF etc;
- Trailing & Forward Multiples are Calculated (2-3 years of multiples)
- Mean & Median Multiple values
The procedure to calculate a multiple can be simply summarized as below
Though the above example is simple, however, for applying the same in real life scenario, one need to establish the value and the value driver and make several adjustments to it.
In my next article in valuation series, I discuss the nuts and bolts of Comparable Company Analysisand how to professionally calculate the multiples and prepare a valuation table like a pro.
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