Enterprise value (EV), otherwise known as firm value or total enterprise value, describes the complete value of a business. This can be calculated using a number of valuation techniques, including discounted cash flow (DCF) analysis. A simple calculation for EV is as follows:
EV = Equity Value + Preferred Stock + Noncontrolling Interest + Capital Leases + Net Debt
Put simply, EV is the theoretical price an acquiring company might pay for another firm. This is useful when comparing companies with different capital structures as choice of capital structure does not affect the value of a firm.
The value of a public company’s equity is the residual interest held by the shareholders after paying off all senior claims (including debt and preferred stock) and is calculated as the current share price multiplied by the number of outstanding diluted shares. To calculate diluted shares, add the number of basic shares found on the company’s latest SEC filing to the number of restricted shares and net shares. Restricted and net shares may result from warrants, convertible securities to get outstanding diluted shares and the exercise or conversion of options.
The treasury method calculates net share equivalents resulting from the exercise of options. This method assumes that proceeds gained from the exercise of options are used to repurchase shares at the current market price and includes all outstanding in-the-money (ITM) options, whether vested or not:
- Net share equivalents = options − (options × exercise price ÷ current market price).
Convertible securities (debt or preferred stock) can be converted into common shares at a specific stock price that is known as the conversion price. Only ITM convertible securities impact diluted share count.
There are several important things to remember that are relevant for EV:
- If the current stock price is greater than the conversion price, the convertibles are ITM;
- ITM convertible securities increase the number of shares outstanding by the amount of new shares issued upon conversion;
- New shares issued = face value of ITM convertibles ÷ conversion price;
- Upon conversion, the face value of ITM convertibles is subtracted from debt or preferred stock, as appropriate, and added to common equity.
Determining whether or not the security is ITM can be difficult, particularly if the convertible security has a fixed coupon interest payment. If this situation occurs, add the current value of all future interest payments (per share) to the conversion price and, using this value, compare it to the sum to the current stock price.
Net debt describes the total debt minus any cash and/or cash equivalents. It is important to consider long-term debt, the current portion of long-term debt and or short-term debt when establishing the total debt amount. Any ITM convertible debt is considered equity and, as such, should not be considered as debt.
When calculating cash and/or cash equivalents for the purposes of net debt calculation, it is important that balance sheet items are available, even if the cash and/or cash equivalents are not classified as assets on the balance sheet. There is no need to include restricted cash for the purposes of this calculation. Restricted cash is often not explicitly identified on the balance sheet but can be estimated depending on the industry. Practically speaking, restricted cash is generally ignored when calculating cash and/or cash equivalents, unless it has been explicitly identified.
When calculating EV, it is important to use the market value of debt in the calculation. In practice, the book value of the debt can be used under the assumption that the debt trades at par. This assumption would, however, be inappropriate in the valuation of distressed companies as such debt will trade significantly below par.
There are other components sometimes included in net debt calculations, including noncontrolling interest, preferred equity not convertible into common stock and capital leases.
Noncontrolling interest, previously known as minority interest, describes the interest held by noncontrolling shareholders in the net assets of a company. This is currently reported in the shareholders’ equity section of the balance sheet.
To give an example, a parent company might have an 80% controlling interest in a firm, while the remainder (the noncontrolling interest) is held by another company. If noncontrolling interest is excluded from the EV calculation, the consolidated earnings before interest, taxes, depreciation and amortization (EBITDA), earnings before interest and taxes (EBIT) etc should be adjusted to exclude the noncontrolling interest (i.e. anything not attributable to the parent company).
Any preferred equity not amenable for conversion into common stock should be treated as financial liability and included in net debt. This will be equal to its liquidation value (i.e. the amount the firm must pay to eliminate the obligation).
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