I read a blog post yesterday over at avc.com introducing the concept of Enterprise Value, as compared to Market Value. AVC defined Enterprise Value as the value of the business without any cash or debt. In a simplistic example, without multiple classes of shares, one would take the market value of the equity, add all debt and then subtract cash on hand (on the premise that, if you bought the company, you could use the cash to pay down the debt).
Enterprise Value is a term I use and hear all the time from those inside and outside the financial world. To me, it is an important valuation tool, but also an over-used and sometimes not well understood phrase. As a result, I have always wondered whether everybody approaches Enterprise Value in the same way – whether we all use the same formula. Interestingly, I have several valuation texts on my book shelf and not one of them provides a definition or calculation of Enterprise Value. Neither does the Canadian Institute of Chartered Business Valuators in their glossary of terms, at least that I could find.
Google was able to find me several definitions, of course. One that I particularly like – it is the sum of the claims of all the security-holders: debtholders, preferred shareholders, minority shareholders, common equity holders, and others. In other words, it is the value of the business, not the company.
Enterprise Value is what you arrive at if you value a business using an EBITDA approach. It is the fair market value of the net operating assets of the company – all of the assets used in the business, including working capital assets, less working capital related debt. A prior post relevant to EBITDA valuations is HERE.
This leads me to wonder about the widely held view that Enterprise Value is simply the value of the business without any cash or debt. To me, this is not entirely accurate – or, at least, overly simplified.
The calculation of Enterprise Value will certainly be influenced by the situation and purpose of the valuation. But, in general, my problem with adding back all debt and deducting all cash from the market value of equity is that, at any point in time, this formula ignores the company’s forward looking working capital requirements. A business must be able to fund its inventory and receivables with cash, operating lines or accounts payable. If not, there is a working capital deficit that must be funded by other stakeholders. Accordingly, if there are continued working capital requirements, the true value of the business, the Enterprise Value, may be less than the simplistic formula implies. In summary, I don’t see a lot of businesses that, if all their cash was used to pay down debt as the formula assumes, wouldn’t immediately require a cash injection from their owner to continue to operate.
So, what should we do?
With respect to adding debt, in my view we generally should not be adding back working capital related debt. Why? Because (normalized) working capital is better considered on a net basis – the amount of your cash, receivables, inventory, operating line and accounts payable are all inter-related, all revolve, and are all part of the operations of the business.
With respect to deducting cash, this idea would be better described as removing all redundant assets. Cash on hand that is part of your working capital cycle should not be deducted, whereas cash that has been accumulated over time and that is not required to support working capital should be removed (because its not part of the operations of the business).
Consider also deducting other redundant assets such as real estate for example. When companies own their real estate, rather than lease, there may be an investment value in the real estate that is redundant to the operations of the business.
Obviously there are many potential adjustments and issues that require the exercise of professional judgement when considering Enterprise Value. As in all valuation matters, the basis of valuation and an accurate definition of the term is always the starting point to determining the process.
I recently spoke with a friend of mine in the merger and acquisition field on this topic. Most M&A engagement letters, explicitly or implicitly, pay success fees off of Enterprise Value, and contain a formula for calculating same. So, I knew he would have an opinion on the matter.
My friend said that he describes the concept to his clients like this: I will buy your house for $100k in cash for the equity, and assume your $900k mortgage. That’s an enterprise value of $1.0 million, and it assumes you paid your utility bill first.
I like that.