Enterprise Value is exactly that: the value of the entire enterprise, not just the value of the common stock. Some investors use Enterprise Value because the measure takes away all (or at least most) of the impact of leverage or debt in a company. Because Enterprise Value is the value an investor might pay to buy an entire company, these investors use ratio analysis in conjunction with Enterprise Value to compare public companies and make investment decisions.
How is Enterprise Value calculated? In large public companies, Enterprise Value is easy to determine.
Take the market value of all the stock and add in the market value of all bonds, notes, commercial paper and so forth. That total is the value of the enterprise. Note that the Enterprise Value of a company is usually much larger than the value of shareholders equity.
In the world of private companies, it's a bit more complicated.
Sale prices for these companies are the market-based measure of Enterprise Value. Because sales price histories as a multiple of cash flow are often readily available, if we know cash flow, we can look to recent sales of similar companies and the cash flow multiples for which those companies sold. Now we can determine the Enterprise Value of the company in question. Subtract all forms of debt and what is left is the value of shareholders equity or common stock. (Add in excess cash or surplus assets if these assets are not meaningfully contributing to cash flow.)
While accounting measures of equity can be negative, the
real market value of equity can not. That's because the limited liability laws for corporations mean shareholders can't be forced to put more money into the company. (Yes, there are a few rare exceptions.)
How can the concept of Enterprise Value be helpful? Last week,
I was talking to a young banker who was trying to help a business owner raise equity for his company. Why? Because the banker's credit department told him that in order to make a loan to the company that would pay off its existing bank line, the new bank would need more equity.
I walked him through the Enterprise Value calculation, given the cash flow of this company and recent cash flow multiples his bank had for the industry. Guess what? The equity value was zero. Five years ago, when the owner bought the company, cash flow was higher and the Enterprise Value was higher - the shareholder was "in the money," but not now.
When I explained to the banker that his equity-raising challenge amounted to finding an investor willing to give the current owner money in the form of equity so the owner could turn the new money into nothing, he decided to keep looking for better prospects.
Sometimes, lenders trick business owners into giving them money by putting money into the company. How do the lenders get that money? Well, if using Enterprise Value, the owner's equity is out of the money. When the company is eventually sold, the proceeds go to the lender or another creditor and not the owner.
In one case, however, the founders got the better of the lenders because they better understood the cash flows and used an Enterprise Value calculation to value the various loans that financed the company. In this example, a successful family business sold out at a high premium to a private equity firm. The deal was financed by a traditional senior bank credit line, lots of so-called junior lien debt, high yield unsecured notes sold to an insurance company and a dollop of equity put in by the private equity firm. The family stayed on to run the company and still owned a sliver of equity.
Over time, sales and cash flow declined substantially and the junior lien lender sold this loan to vultures that wanted to take control of the company. The family did an Enterprise Value calculation based on where they thought the company was headed (i.e., further south) and concluded that the junior lien loans now owned by the vultures were worth very little and everyone below that was toast. The family agreed to put $10MM into the company, but as a secured note that was senior to the junior lien loan. After cash flow declined further, the family converted its loan to equity and the vultures, that held the pre-existing junior lien debt were, well, toast.
A few Enterprise Value pointers - Get expert help. Experts have access to relevant sales multiples. Also, and as even these few simple examples highlight, there are many nuances and details that need to be considered. These are things with which an expert will already be familiar.
- Remember EBITDA. Earnings before interest and taxes, or EBITDA, is a common measure of cash flow. However, don't forget to subtract ongoing capital expenditures needed to support the business.
- Add back major perks. For a serious buyer, you will need to document the perks and have better financial records than just prior years' tax returns
- Consider other major creditors. These may not be on the balance sheet or as obvious as a bank. Significant real estate leases and unfunded pension liabilities (particularly for a union) are two examples.
While a bit arcane and complicated,
understanding Enterprise Value is essential to valuing the stock and loans that finance a private company. As the stories show, the stock or loans can be worth less than their stated value.
