Enterprise value - how much is a business worth

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How much is a Business worth ? Or ... How much value is the market giving for company X’s business? Some will think that the answer to this question is simple. Such value is the Market Capitalization, defined as ...


Market Capitalization

It’s the market value of the outstanding shares of a given company. It’s just the number of outstanding shares multiplied by their price (present quote). Or, in the case where’s significant dilution provoked by the issuing of stock options/warrants, the number of diluted shares multiplied by their price (present quote).

However, it’s not that simple

The value the market is giving to the company’s business depends o­n more factors. For instance, it depends o­n the debt the company carries. Lets imagine that company X has just a single asset, a home worth 250 000 USD. And company Y has a similar home, but also debt of 150 000 USD.

What can we conclude? The value of the “business” of both companies, the home, is exactly alike. But the value of the Market Capitalization of each of these companies would be very different (close to 250 000 USD for X, and just 100 000 USD for Y).

So there has to be a different concept from Market Capitalization, which is …

The Enterprise Value (EV)

This is the real value the market is giving for the company’s business, taking into account that a Dollar of Debt would be a direct substitute for a Dollar of Market Capitalization.

Why must if be like that? Well, because it’s theoretically the same to pay 900 for company A with a debt of 100, as to pay 100 for the same company with a debt of 900. And it’s the same because you could engineer the acquisition of company A in such a way, using an LBO – leveraged buyout – that the end result would be the same in both cases.

We should note that the debt we have to add is “Net Debt”, or Remunerated Debt (short and long term bank debt, notes, bonds, capital leasings) LESS Cash and Cash equivalents. If the Cash items exceed debt, then “Net Debt” will show up as a negative number.

Besides debt, we also have to correct Market Capitalization because of minority shareholdings. This is because the business being valued might not all be owned by the company we’re analysing. Thus, if the company owns o­nly half the business, when the market gives that company a Market Cap of X, it’s saying that the business is effectively worth X * 2. The easiest way to correct for minority shareholdings, is to take the minorities number from the Balance sheet and multiply it by a Price-to-Book of similar businesses, or lacking that, the Price-to-Book of the company we’re analysing itself.

One last correction is made because of non-operational Assets which the company might have, and which if sold wouldn’t hurt the performance of the business. These, if they exist, can be sold and the product of the sale would make the debt be smaller (or the Cash pile larger), thus we have to reduce the EV by their value (examples here could be real estate investments, a stock portfolio, etc).

So, Enterprise Value is the sum of Market Capitalization + Net Debt + Minorities at market prices – Non Operational Assets. Many times and for a multitude of stocks, we can simplify this by just considering Market Cap + Net Debt, but o­ne should be aware that this can lead to significant distortions o­n the calculations (making for missed opportunities, or making something dear seem cheap).

And what is Enterprise Value good for?

The Enterprise Value is particularly useful in the calculation of valuation multiples that are much more stable and with greater predictive value, such as EV/EBITDA, EV/FCF or EV/SALES. These multiples allow for easier comparisons between companies in the same sector, or even between companies from different sectors, as they eliminate distortions coming from different debt levels, minorities or non operational assets. We will talk about these multiples in later articles.

Little known curiosities about Enterprise Value and multiples using it

It’s different for the Debt to be at the Holding we are analysing, or in some sub-holding where there are minority shareholders. This happens because if we had a equity call o­n the sub-holding, the Holding would o­nly answer for its % of the equity, and thus EV would decrease because of the debt that would be paid with minorities’ equity.

When we are calculating multiples using EV, it’s useful to see how much of that EV comes from Market Capitalization, and how much comes from Debt. This is because when the biggest % comes from Debt, the gearing of the companie's valuation is larger, which means a curious thing: is a company carries a lot of debt (lets say, 9/10ths of the EV is Debt), the stock can go up incredibly without it becoming much more expensive (for instance, in this example if the stock goes up 10X, the EV would o­nly double). These situations are VERY interesting when we find a successful turnaround with lots of debt.

Also, beyond what was said in the previous paragraph, if a company has a very high % of its EV in Debt and they manage a successful turnaround, they will gain a lot of value merely because of debt reduction. For instance, if 9/10ths of the EV is debt, and the company pays 1/9th of that debt in a year, it’s Market Cap should approximately double just because of that fact.

On the other side, when a large % of the EV comes from negative Net Debt (Net Cash), the opposite happens. Although the company might seem very cheap in terms of EV multiples, any small appreciation in stock price will mean those multiples will rapidly deteriorate, because there will be a lot of negative gearing. So, these situations might be easier to identify in terms of undervaluation, but the upside will be much smaller.


Author

Incognitus, Think Finance