Enterprise Value vs Equity Value
In this article, we discuss Enterprise Value and Equity Value in length, how they work, their differences, and explore the various avenues of their utility.
Enterprise Value vs Equity Value is a debate faced during a company takeover. Both are methods of company valuation and form the foundation of various valuation multiples, but each functions differently. Based on the nature of the industry and business strategies, one method is preferred over the other—no regulatory obligations surrounding their usage. The final decision lies with the valuation firms facilitating the merger.
Overview of Enterprise Value Vs Equity Value
Every company is made of various classes of assets and liabilities. When a business is considered for a potential takeover, it is natural for the acquirer to employ different financial models to arrive at a realistic acquisition cost. This includes accounting for the book value and the market value of all tangible and intangible aspects of the new business.
Enterprise Value (EV)
The easiest way to estimate a company’s market value is to calculate the market capitalization (market cap). Simply multiply the total number of outstanding shares by the price per share. However, this outlook has heavy limitations. Market cap only considers common shares. A company’s capital structure has many more aspects beyond common shares as well. This is the primary difference between enterprise value vs market cap.
Enterprise Value (EV) is a comprehensive company valuation method that involves all aspects of company ownership. It goes a step beyond the market cap and accounts for all outstanding debt plus net cash (including cash equivalents). It is a detailed, theoretical calculation of a company’s worth in the market. Needless to say, investors and big businesses looking to invest or take over a new business rely more on EV to understand the extent of profits and liabilities arising out of an acquisition. Another important aspect of enterprise value vs market cap is that market cap fluctuates based on trading trends while the former does not.
As the name suggests, equity value is the total share value of a company. It is often used interchangeably with the market cap but is not the same. Market cap only accounts for common shares, while equity value accounts for common shares along with preferred shares and convertible notes. These are generally considered as debt extended by shareholders. They do not immediately reflect as issued stock but convert on a later date. For all practical purposes, they are company stocks and they must be accounted for. It even goes a step further to include the value of all outstanding shares.
Enterprise Value vs Equity Value, when compared, reveal valuable information to two different groups of stakeholders. The former provides a holistic view of a company. It helps investors make profitable decisions, while the latter concentrates on net share value and helps shareholders and company management understand the company’s present health and make necessary changes to enhance profits.
Key Differences Between Enterprise Value and Equity Value
Since equity value is dependent on stock prices, in a way, it is an integral part of enterprise value calculations. But as a standalone company valuation metric, the differences between these two are quite obvious. Here are some of the aspects where enterprise value (EV) and equity value differ:
- Industry focus – EV is a diverse and holistic company valuation metric. It works well for all industries except banking, insurance, and those operating with high debt levels as a business strategy (e.g. heavy machinery). Equity value, though dependent on stock market fluctuations, applies to all types of industries.
- Beneficiary – EV provides the net value of a company for investor purposes. Investors must know the accurate picture while taking over a company or investing in it for a considerable stake (not just the market impression of the company based on the share price). On the other hand, equity value provides the net value of equity a company directed towards shareholders and company management. It is a valuation metric that these stakeholders use to understand the financial health of a company.
- Fluctuations – One of the fundamental differentiators between enterprise value vs equity value is that the former is not affected by changes in stock price. Though the market cap is included in the calculation, the total EV is immune to market fluctuations. This is not the case with equity value. It is solely dependent on stock prices and will fluctuate with the rise and fall of stock markets. Another aspect is that EV accounts for the changes in total debt, interest generated from income, and expenses. Equity value does not account for these and focuses only on the changes in equity-related values.
- Pairing – EV is paired with all current information (i.e.net operating assets). This makes sense as an investor needs the present status quo to decide which company to prefer. But equity value is paired with all assets current as well as in the future (i.e. net assets). Equity in a company, in many ways, is a function on time. As a business grows, new shares are generated, of which some are issued, while others are kept on hold for the future. It accounts for all possibilities present and future.
- Cash flow accountability – EV accounts for those cash flow mechanisms that are concerned with investors alone. This is why unlevered free cash flow is discounted by WACC (weighted average cost of capital). Meanwhile, equity value accounts for cash flow mechanisms that indicate shareholder profits. Thus levered cash flow is discounted by the cost of equity. This is an important aspect while comparing these two values.
Calculation of Enterprise Value vs Equity Value
When compared, these two values have many differences. However, both have some variations to the formula. One is simple, and the other a bit more elaborate. Depending on the company size and stage of growth, each of these elaborate formulas plays a role in accounting for all aspects of company ownership. Let’s take a look:
Enterprise Value Formula
The simplest version of the enterprise value formula is:
The more elaborate version is:
- Total value of common shares or Market cap = Total number of common shares * price per share
- Preferred shares – Regular dividend-generating shares, considered as debt
- Total value of debt – Government and private loans, both long-term and short-term
- Minority interest – Value of less than 50% stakes in other companies
- Cash & Cash equivalents – all liquid assets of the company
Example of calculating enterprise value
Let’s consider a company ANC. Inc. To calculate the EV of this company, as per the formula, we must calculate the market cap. Let’s say the company has issued 2,000,000 shares, and each share is valued at $10.
This is the total market value of common shares of ANC. Inc. Further, let’s say:
- Market value of preferred shares = $1,000,000
- Market value of total debt = $1,000,000
- Market value of minority interests = $1,000,000
- Total value of cash = $2,000,000
EV = $21,000,000
EV = $21,000,000
Equity Value formula
The simplest version of the formula is:
The most elaborate version is:
Example of calculating Equity Value
Following the previous example of ANC Inc, the calculations will be:
Equity value = $20,000,000 (which is equal to the initial Market cap of ANC Inc.)
Equity value = $20,000,000 (which is equal to the initial Market cap of ANC Inc.)
This is a simple way to understand how company valuation calculations work with enterprise value vs equity value. At the onset, equity value might come across as the same as market cap. This is what the above calculations reveal as well. But it will differ in the case of companies with large volumes of non-operating assets beyond the market cap value.
With varying balance sheets for companies across different industries, professional valuation experts must be engaged to ensure that all components of a company’s ownership structure are accounted for. Otherwise, stakeholders will be misled into making hasty, ill-informed investment decisions.
Points to Consider in Enterprise Value and Equity Value Calculation
These two values are quite simple to understand. However, there may be variations at times. An analyst must have a clear understanding of how these values vary and read them right. Here are two basic factors:
The importance of any valuation metric lies in its ease of comprehension. On this note, it is useful to consider that EV can be negative and still indicate a profitable takeover. For example:
- Market cap of XYZ.Inc = $1,000,000
- Debt = $50,000
- Cash = $2,000,000
Though the value is negative, the financial health of this company is positive, and the acquiring company will benefit from the low debt liability and surplus-value of cash.
However, this problem does not arise with equity value. Since it is a direct measure of company equity that can never be negative, they are always positive.
Effect of financing events
Financing events typically affect the total number of shares. Every time a new round of funds is injected, investors demand equity in exchange. Most often, alterations to the equity structure are demanded pre-money, which includes changes such as expanding the options pool as well. Also, many pre-issued stocks convert at a financing event while new ones are issued. In theory, any financing event should affect the equity value of a company.
Between these two values, since EV concentrates only on the net operating assets, in theory, financing rounds should not affect its overall value. Major changes in enterprise value are observed only when there are alterations in the net debt or cash value.
Relevance and Uses of Enterprise Value and Equity Value
- EV is directly associated with company valuations during mergers and acquisitions, while internal stakeholders use equity value to analyze business trends and change or edit courses accordingly.
- EV is used by investment bankers to advise companies for a takeover or a merger, while research analysts use equity value to advise individual stakeholders to buy or sell company stock for profits.
- The enterprise value formula comes in handy in company valuation when two companies have a similar market cap. EV helps make that distinction of a profitable takeover by pointing out the effects of company debt and cash reserves.
- While comparing enterprise value vs equity value, EV gives a more realistic picture of a company value because it involves the debt component. An investor acquiring a company will be responsible for taking overall liabilities of debt. This is crucial information before closing an acquisition deal.
- Similarly, EV points out the cash reserves of an acquiring company as well. This is helpful for the investors because most often they use this surplus cash and cash equivalents to pay off carried over debts: higher the cash reserves, better profits for the acquiring company.
- The enterprise value formula reveals the EV. But EV’s utility is better understood in the way it functions with valuation multiples. EV is fundamental to many valuation metrics such as EBITDA, EBIT, FCFF, and many more.
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As we see, company valuation is a tricky process. What works for one business may not work for another. Many underlying factors need to be considered before choosing the most suitable company valuation method. It is best done with the help of professionals. Eqvista is the pioneer in cap table management and company valuations. For any queries regarding company valuation, reach us today.
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