For anyone new to investing, or possibly a veteran investor who's using valuation techniques, you may have noticed that there two different numbers (Equity value vs enterprise value) used to calculate the total value of a company - the equity value (or market capitalization) and the enterprise value.
While both serve the purpose of putting a value on the company, they are calculated differently and give you a slightly different picture of the company's price tag or worth. However, it is not a surprise that these different value measures sometimes lead to confusion also.
In this article, I will explain one of the most confusing / misunderstood topics for many professionals, i.e., the basic difference between the two – equity value and enterprise value.
The ‘Equity Value’ refers to the value held by its equity owners while ‘Enterprise Value’ refers to the total value of the business, including value held by its equity owners and its debt owners.
Not let me give you a live example to make you understand better –
A few weeks back, a friend of mine bought a house.
He was happy to share the news with all friends.
He threw a big party and celebrated the purchase of this true asset. While discussing the cost of this asset, he explained the various costs attached to it.
The actual acquisition cost of the house was 10% more than the list price.
Well, it included hidden costs like repairs to be done, unpaid bills, different obligations, and various registration costs.
But, my friend benefited from furniture that he got free with the house.
Okay! You will ask me what this house story has got to do with the headline of this article, right?
Now, imagine you are an equity research analyst and working on the valuation of a company to be acquired.
Take the essence of the house story in this context and you will understand the difference between equity value and enterprise value clearly.
Equity Value vs. Enterprise Value
Equity value will tell you what a company is worth, and enterprise value tells you how much it would cost to acquire a company in totality.
So, in my house story, the list price is equity value, whereas, the addition of 10% to list price would give you the enterprise value of that house.
Enterprise value will take into account the debt part, obligations and the free things like cash that the company has.
Valuation of Equity/ Equity Value formula
= Common Shares Outstanding * Share Price
The equity value/market capitalization is defined simply as the total value of all outstanding common stock of the company.
Since the ownership of a public company lies in its outstanding shares, the theoretical price to buy the entire company would be the price of a single share of stock multiplied by the number of shares currently outstanding.
Enterprise Value Calculation
= Equity Value – Cash + Debt + Minority Interest + Preferred Stock
For example, let's assume Company XYZ has the following characteristics:
Shares Outstanding: 1,000,000
Current Share Price: $5
Total Cash: $500,000
Total Debt: $1,000,000
Minority Interest: $50,000
Preferred Stock: $75,000
Based on the formula above, we can calculate Company XYZ's enterprise value as follows:
($1,000,000 x $5) - $500,000 + $1,000,000 + 50,000 + 75,000 = $5,625,000
Why Do we Subtract Cash from Enterprise Formula?
In the house analogy, cash would be equivalent to the furniture that my friend got for free.
From one perspective, the furniture may be considered as a part of the house, as it is kept in the home and adds to the owner’s residence.
However, it is clearly and distinctly a separate asset that may easily be removed without adversely impacting the functional value of the house. Should the selling homeowner offer to include the furniture value in its sale price, he would expect a little more to be paid.
The same analysis holds true in selling a business.
Cash on the balance sheet of the company being acquired is a distinctly separate asset that may easily be removed without adversely impacting the functional value of the business.
This is not the case with other assets such as computers, office furniture, etc., all of which would need to be replaced by further cash outlay if removed by the seller.
Remember the free furniture my friend got with his house purchase?
That’s a gift, and his cost of acquisition would be reduced by the furniture cost.
Simple, he doesn’t have to invest money in buying new furniture, and that will save him a lot of money.
In the same way, if you are acquiring a company having some cash (including short-term and marketable liquid investments) on its balance sheet, you will pocket that cash and your acquisition cost will be reduced effectively by that amount.
Why Do We Add Debt in Enterprise Formula?
The answer is very simple. After the acquisition, you are taking up liability in your name and hence you are required to pay it off.
You will have to pay the debts that include short/long term debts, revolvers, mezzanine and so on.
Why add Minority Interest?
Minority Interest refers to that share of stock of a Subsidiary Company (those companies in which the parent company holds more than 50% stake) which is not owned by the parent company.
So it is that share that is not owned by the company that you will be acquiring and hence, you have to pay for it separately and thus added in the formula.
Why Add Preferred Stock in Enterprise Formula?
Preferred equity that is not convertible into common stock is treated as a financial liability equal to its liquidation value (the amount the firm must pay to pay off the obligation), and thus, the company will have to pay it separately, thereby increasing the cost of acquisition. Hence, it added to the formula.
Let us summarize the difference between Equity Value and Enterprise Value:
My friend is happy with the newly acquired house.
As an Analyst, your role is to see your clients happy with the acquisition of the companies.
I hope, you are now clear with these two concepts: Equity Value and Enterprise Value.
In light of the above, it can be concluded that Enterprise Value is a more preferred valuation technique by business analysts since the same take into accounts various other components like minority interest, preferred stock, cash, and cash equivalents, etc. in addition to the equity value, which is ignored in while computing a business worth using Equity Value formula.
I hope the above has made a clear understanding of Equity Value and Enterprise Value.
In careers like Financial Modeling and Investment Banking, you need to calculate equity value, enterprise value, understand the capital structure of the business, debt, and cash available, use discounted cash flow valuation, enterprise value multiples in company analysis.
Enterprise value matters when a company wants to buy another company.
We cover all this in our financial modeling and investment banking training programs.
Have you bought any asset that explains these two concepts- Equity Value and Enterprise Value clearly? Share your experience here.