Reading: Enterprise Value, Equity Value, and Multiples

The idea behind "Enterprise Value" is to provide an estimate of the market value of the firm's operating business activities. The preceding section has introduced the most popular definition of enterprise value (EV), which is:

 

 

Because it is so popular among financial analysts, it is worthwhile to spend a few moments to understand the various ingredients of this formula. By now, the first element of the equation, the market value of equity, probably does not need much additional explanation. But what about net debt? For most non-finance people the use of net debt might not be very intuitive. Therefore, let us quickly look at the definition of net debt, how we can measure it and why we actually use it. Then, we turn to a real-life example to practice the measurement of enterprise value.

 

Definition of Net debt

Net debt measures the firm's debt outstanding, net of its cash (and short-term investments): 

 

If we plug this expression in the definition of enterprise value above, we get:

 

This is important to remember: The common definition of enterprise value does NOT include the firm's cash holdings and short-term investments!

 

Measuring Net debt

In most valuation situations, book values provides a good approximation of the market value of net debt. Consequently, we can use the information in the firm's balance sheet to measure net debt:

• Debt: All the firm's financial liabilities (everything the firm borrows from banks and other providers of capital). Operating liabilities such as accounts payable, taxes payable, etc. are NOT part of the financial liabilities. For a detailed discussion of operating vs. financial liabilities, please refer to the module Financial Analysis.
• Cash and short-term investments: In principle, we want to measure the firm's excess cash, that is, the cash that is not required to secure a smooth operation of the business (see the module Financial Planning for a detailed discussion). However, most analysts simply approximate Cash and short-term investments with the balance sheet items "Cash and equivalents" and "Short-term investments." 
   

Why do we use Net debt instead of Total debt?

To understand why we use Net debt instead of total debt, it makes sense to go back to the original definition of enterprise value at the beginning of this section. There, we have argued that enterprise value reflects the market value of the firm's operating business activities. By definition, (excess) cash is not part of these operating activities, but rather the result of them (i.e., the fact that the firm has run its operations successfully in the past). 

This definition of enterprise value has two important interpretations:

• Enterprise value tells us how much we would have to pay to assume full control over the firm's operating business activities: Purchase the equity, assume all debt outstanding, and then use the firm's excess cash to repay some of the debt. We will look at this interpretation in more detail in the example below.
• This definition of enterprise value also makes valuation multiples more comparable across companies with similar operating business activities. Cash and short-term investments do usually not contribute directly to the value indicators we use to normalize enterprise value, since Sales, EBIT, and EBITDA all exclude interest income (at least for firms outside the financial industry). If the denominator of the multiple is unaffected by excess cash, it also makes sense to use a numerator that is free of cash holdings. Otherwise, the resulting valuation will not adequatly reflect the value of the firm's cash. 

 

Example

Suppose we want to estimate the enterprise value of Microsoft Corp. in December 2016. To do so, we have collected the following data:

• Stock price: $62
• Number of shares outstanding: 7.8 billion
• Debt outstanding (book value): 53.7 billion
• Cash and short-term investments: 113.2 billion

 

WIth this information, we can compute Microsoft's market value of equity and net debt using the equations above:

 

 

Note that, since the firm's cash balance exceeds the amount of debt outstanding, net debt is actually negative. Now we are ready to compute Microsoft's enterprise value:

 

What's the interpretation of this number? 424 billion is our estimate of the market value of Microsoft's operating business activities. In principle, this is how much it would cost an investor to assume full control over the firm's business:

• Purchase all the equity for 483.6 billion
• Repay all the debt outstanding for 53.7 million

 

Consequently, taking over all financial claims against the firm will cost the investor 537.3 billion (= 483.6 + 53.7). This is the total value of the firm's debt and equity. Once the investor has full control, she can take the excess cash of 113.2 billion and pay it out as a dividend. Ignoring tax considerations, the acquisition price of the firm's operating activities will, therefore, be 424.1 billion (= 537.3 - 113.2). This is the enterprise value.