Business Valuation
Apr 29, 2023
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This guide explains what equity and enterprise value are and it explains the difference between them. First, we will look at what equity and enterprise value are, and then we will look at how they are used in valuation. Here are some key takeaways about equity and enterprise value:
The best way to understand enterprise vs equity value is to use a residential house as an example. For this example, we’ll look at two identical houses, both worth $250,000.
The first house is owned with a mortgage, the owners have 20 percent equity ($50,000), and 80 percent is owed to the bank ($200,000).
The second house is owned outright by the owners who have $250,000 in equity and have no mortgage balance outstanding.
Both houses have the same enterprise value—$250,000. Enterprise value is the value of the house without giving consideration to the portion of debt or equity that the home owner used to buy it. Along the same lines, in business, enterprise value is the value of the entire business without giving consideration to the business’ capital structure. Assets = debt + equity and enterprise value gives us the value of the entire business.
Going back to our example, while the enterprise value of the two houses is the same, the equity values of the houses are different. In the first house, the owner has $50,000 in equity and in the example of the second house, the owners have $250,000 in equity value.
In business, equity value is the value of the entire business minus the net debt the business has. This gives us the value of the company that shareholders would be able to receive if the company were to be sold. In the event of a sale, or liquidation, debt has a higher liquidity position than equity. In order for the shareholders (the ones with equity stake) to be paid out, the debt needs to be repaid first.
Back to our example of the two houses, both could be sold for $250,000—the enterprise value gives us a way to understand the value of the whole asset, regardless of how it is financed. But after the sale of the house, one homeowner would receive $250,000 while the other would receive only $50,000. This is illustrative of how any debt investors in a business would need to be paid back before the shareholders (the ones who own equity).
To drive the point home, consider both enterprise and equity value of the houses if the market dropped and the homes were now worth only $190,000. In this example we’ll assume that both homeowners needed to sell at that time. Here the enterprise value for both is $190,000, again it’s the same. But the example shows us how the equity value gives consideration to the capital structure (how the assets are financed) while the enterprise value does not. In this example, the second homeowner would have $190,000 in equity value, and the first homeowners would have -$10,000. Meaning that they would owe the bank $10,000 by selling their house at that price.
If these houses were businesses, the shareholders in the first house would receive nothing in the event of a sale or liquidation because the business’ debtholders would need to be paid off first. Note that they would also have lost money in this transaction because the sale price wasn’t enough to recoup all of the money owed to the debt investors. The other business would have been able to pay out their shareholders $190,000.
Private company valuation is both an art and a science. To learn more about it, we recommend our guide: Intro To Private Company Valuation. In that guide, we explain that the objective of business valuation is to come up with a range of prices that might make sense to pay for a business, through the use of several different types of valuation methods.
Once this price range has been determined, the acquiring business can approach the seller and begin negotiating. It’s important for both the buyer and the seller to understand what a business is worth before a deal can be agreed to.
When valuing a private company, we would use the discounted cash flow (DCF) method to find the enterprise value of the business. Here is how a discounted cash flow valuation is calculated:
With the discounted cash flow method, we take the unlevered free cash flows of the business (numerator) and discount them backwards in time (denominator) to see what it is worth paying today for the expected cash flows the business will produce in the future. We won’t go into more detail about calculating a DCF valuation in this guide, but you can learn more about the discounted cash flow valuation method here.
When we use the unlevered free cash flows we are looking at the cash flows that are available to all capital providers. Note that this takes into account all of the capital providers, the debt investors and the equity investors. Remember, that enterprise value is the total value of the business without giving consideration to its capital structure. When we discount these unlevered free cashflows back at the weighted average cost of capital (WACC), we arrive at our enterprise value.
So a discounted cash flow (DCF) valuation gives us our enterprise value.
Once we have our enterprise value for the business, we can calculate the equity value. Remember that equity value is the value that shareholders would receive if the company was sold. Equity investors have a lower liquidity position than debt investors so debt needs to be repaid before equity investors can be paid out. (You can learn more about debt and equity investors here.)
To calculate equity value from enterprise value, we need to determine how much debt needs to be repaid before the equity shareholders can be paid out. We determine this by calculating net debt. To get net debt we add up the long-term and short-term debt the business has and we subtract any cash. So if the business has $1 million in debt, and has $250,000 in cash, then the net debt would be $750,000.
We arrive at the equity value of the business when we subtract the net debt from the enterprise value of the business.
There is an important distinction to make here for the sake of understanding the business’ financials. While subtracting the net debt is the proper way to determine equity value for the business, we have to understand that calculating net debt is not the same thing as calculating debt outstanding. In the example above, the business still owes $1 million in debt (debt outstanding), irrespective of how much cash it actually has on hand.
Equity value shows us what the shareholders would be paid out in the event of a sale but it doesn’t mean that the business is required to use all of its cash for debt repayment. The assumption here when calculating equity value is that the debt would need to be paid back to facilitate the sale. If the business is a going concern, meaning that it intends to operate indefinitely into the future, then the company may or may not choose to use that cash to actually pay down the debt.
Now that we've looked at the difference between enterprise and equity value it's important to clarify a few points.
First, you could structure a DCF valuation to directly give you the equity value of a business.
In order to do this you would use the levered free cash flows in the numerator instead of the unlevered free cash flows. Additionally, you would want to adjust your discount rate (denominator) to reflect the cost of capital to equity shareholders. Using the WACC would be incorrect in this case because it reflects the cost of capital to all investors. This would create inconsistency between our numerator and our denominator (our logical argument would not make sense).
Doing a DCF valuation this way would give you the equity value of the business.
While this is possible, it is much more practical to structure your DCF valuation to give you the enterprise value of the business (unlevered free cash flows / weighted average cost of capital).
This will allow you to compare your DCF valuation to other companies while intentionally disregarding their capital stack. Companies choose to finance growth with debt or equity for different reasons and it's confusing to compare a company with debt to a company with no debt if you don't use enterprise value. If we look past this decision, we can look more objectively at operational performance. Remember that debt is eventually paid off.
Obviously if a company has too much debt this presents risk, but this is easy to observe and think about on its own. For more on this, we recommend our guide on interest coverage.
So, DCF valuations are more useful when structured to represent enterprise value, and once you have this enterprise value it's easy to calculate equity value anyway. To do this, you simply subtract net debt from the enterprise value.
Second, we don't need to use a DCF to get enterprise value. Other valuation methods such as precedent transaction analysis will give us an implied enterprise value because the sale here represents the market value of the business.
However, DCF valuation is probably the most reliable way at looking at enterprise value pre-transaction. This makes it useful if you're trying to understand enterprise value for a business that hasn't sold yet.
