By Drew Hutcheson
Also known as firm value, enterprise value is defined as the value of an entire business, including debt lenders and other obligations as seen in the below formula:
EV=equity value + short term debts + long term debts + current portion of long term debts + capital lease obligations + preferred securities + noncontrolling interests + other nonoperating liabilities – cash and cash equivalents(emphasis mine)
The importance of enterprise value cannot be overstated as it’s the numerator for several key valuation formulas, not the least of which is EV/EBITDA which basically takes the worth of a company and divides it by its ability to generate profits on a normalized basis.
In Pignataro’s LBO book, he outlines a helpful way to correctly arrive at a company’s EV, allowing you to also check your calculation. Namely, he says a company’s EV should be equal to their PP&E + working capital (WC). He arrives at this by doing the following.
Actual balance sheet items:
Shareholder’s equity [or market cap] + accounts payable + accrued expenses + short term debt + long term debt = cash + accounts receivable + inventory + PP&E
He’s assumes the company has no noncontrolling interests or prefs and no other nonoperating liabilities, but just has short and long term debt.
Then, we move everything not related to debt, namely, AP and AE, to the other side of the equation, giving us (abbreviated for simplicity):
SE + STD + LTD = Cash + AR + Inv. + PP&E – (AP + AE)
When you look at this you realize that “AR + Inv. – AP – AE” is really just the company’s working capital, or WC (current assets less current liabilities). Thus, the equation then becomes: SE + STD + LTD = Cash + PP&E + WC
We then subtract Cash from both sides and we arrive at:
SE + Net Debt = PP&E + WC
The key takeaway here is that in adding net debt to the company’s market cap, we’re actually backing into the value of the company’s PP&E and WC; the core operating assets of the company. Hence, “EV is a way of determining the implied value of a company’s core operating assets.”
Feel free to share any additional thoughts on the subject.
*This post was originally published on LinkedIn here and has been used with permission.*