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3. Enterprise Value and Equity Value
The concept of company valuation is much easier to understand when we distinguish between the Enterprise Value and the Equity Value of a company. In this lesson, I help you to understand and calculate these important values.
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Lesson Goal (00:04)
The goal of this lesson is to learn about the two main definitions of value: equity value and enterprise value.
Simple Example of Equity and Enterprise Value (00:34)
The equity value of a company is the value placed on all outstanding shares in the company. By contrast, the enterprise value represents the value of all the assets of the business. This means it also represents the amount it would theoretically cost to take over the business.
For example, if a company has $150,000 in cash and no other assets, its equity value and enterprise value are both $150,000. If the company takes out a $150,000 loan, and uses this loan and its cash to buy a $300,000 property, then the equity value will not change, as the value of the company’s shares is still $150,000. The enterprise value will be $300,000, as a buyer would need to acquire $150,000 of shares and $150,000 of debt in order to own all the assets of the business.
Formula for Enterprise Value (01:58)
As we have seen, a company with debt has a higher enterprise value than a company without debt, as a buyer needs to pay off this debt in order to own the company’s assets. However, if the company has a cash balance, this can be used to pay off debt, reducing the amount a buyer would need to pay. As a result, we can derive the following equation for the enterprise value of a company:
\(Enterprise Value =Equity Value + Debt - Cash\)
This is a simplified equation for calculating enterprise value, but it will work for our purposes.
When the Enterprise Value Changes (03:52)
The enterprise value of a company should theoretically not change after a financing event. For example, if a company acquires a loan, debt will increase, but cash will increase by the same amount, leaving the enterprise value unchanged.
The enterprise value should only change after an operational change, such as shutting down a business unit, or projecting higher future revenues. It can also increase if a business acquires a loan and then spends that money on acquiring new assets or paying expenses.
Learn more about the enterprise value at these links:
When we speak about value and the process of valuing a company, it's important to be clear about what exactly value means. For example, if I buy an apartment for $300,000 with a loan of $150,000 what is the value of my investment? In this lesson we're going to clear up any ambiguity that exists around the definition of value by introducing two new terms: Equity value and enterprise value. Let's start by looking at equity value. The definition of equity value is the value we put on all the outstanding shares of the company. Let's explain this with a simple example. I have a company with no assets apart from $150,000 in cash.
I use this cash to buy an apartment for $300,000.
As part of the deal the company takes on $150,000 in loans from the bank to pay for this apartment. The day after acquiring the apartment the value of the company is still $150,000 from an equity value perspective. If you were to buy this company, you could purchase the shares from me at $150,000, and you would also be taking on the debt from the bank. Alternatively, you could pay the enterprise value and purchase $150,000 in shares from me, and $150,000 in debt from the bank, which will in total cost $300,000. And this is the amount it costs to theoretically take over all the assets of the business. In this way the enterprise value can be thought of as the theoretical takeover price if the company were to be bought. Let's explain this a little better by adding some complication to the previous example. I still retain $150,000 in cash in my company, but this time I buy a different apartment for $330,000.
And to fund this, I get a loan of $200,000 from the bank.
This leaves me with remaining cash of $20,000. So now I need to think about my equity and enterprise value. My equity value the day after purchasing the apartment is still the same at $150,000, which should be enough to purchase all the outstanding shares of the company. The enterprise value is different, however. Remember the enterprise value is the theoretical takeover price of the company if the company were to be bought. So let's work this out. The company has an equity value of $150,000, it has loans of $200,000.
These numbers both need to be accounted for as part of the enterprise value calculation. I have remaining cash of $20,000, so in effect the takeover price would be $150,000 plus $200,000 minus the $20,000 I have in remaining cash, leaving me with an enterprising value of the $330,000.
It also leaves me with a simplified equation for calculating enterprise value, which is equal to equity value plus the value of the debt minus the cash in the Balance Sheet. And just to reiterate, in this example it's $150,000 plus the $200,000 minus the cash leftover which is $20,000.
Bear in mind this is a simplified equation for enterprise value, but will work perfectly in all examples in this course. What you may have noticed about the enterprise value formula shown on this slide is that a financing event shouldn't theoretically change the enterprise value. If we take on additional debt, say $100,000, the debt goes up, but so does the cash.
And so the enterprise value doesn't change. The enterprise value will only change if the company's core operations change. If we have a financing event, such as, repaying debt, raising equity, repurchasing shares, or issuing dividends, then in all these cases the equation should balance so that enterprise value stays consistent. However, enterprise value will be effected by operational changes, such as shutting down an unprofitable unit, or projecting higher future revenues.
Enterprise value can also be effected if a company acquires loans from the bank, and spends this money on assets and other expenses.
In all our company valuation courses we will calculate both the equity value and the enterprise value. For more information on these two concepts I have included some links to online resources in the show notes for you to read.