The term enterprise value is typically used to refer to the total price someone would have to pay to acquire a business (i.e. to purchase all the equity in the business and as a result, assume all of its debt liabilities). A buyer might choose to pay off debt immediately post-acquisition or to pay it off later. In other words, enterprise value refers to the true cost of owning the business.
Enterprise Value = Equity Value + Net Debt
- Equity Value: this essentially refers to the market capitalisation of a business.
- Net Debt: this is a metric that measures a firm’s ability to repay its debts if they were all immediately due. Cash and cash equivalents that sit on a company’s Balance Sheet are subtracted from the total debt to give the ‘net debt’ as these items could theoretically be used to immediately pay off some of the debt. Net debt will be a negative number that contributes to a reduction in the enterprise value figure.
The above formula is a simplified illustration of the calculation of a company’s enterprise value. Although this will often suffice for the purpose of an interview, it is useful to note that a number of additional items are often added and subtracted to this simplified formula in order to yield a more precise definition of ‘enterprise value’.
Earnings Before Interest, Tax, Depreciation & Amortisation (EBITDA)
EBITDA is one of the most commonly used profit metrics in investment banking. The metric is useful because it excludes items that are subjective or unrepresentative of a firm’s true ability to generate cash. No account is taken of any interest or tax payments made, or any accounting adjustments made to reflect the depreciation of assets or amortisation. These exclusions make it easier to compare two similar companies on a like-for-like, operational basis, providing investors with a better indication of which company is more inherently profitable.
- Interest: excluded because interest figures are affected by a firm’s capital structure (the amount of equity it has issued and debt it has taken on). If Company A and Company B were exactly the same (produced the same products, incurred the same costs and sold them for the same price), but Company A had borrowed more capital than the other, the additional interest payments paid by Company A would likely result in Company B reporting greater profits (even though Company B has equal potential to generate similar profit, pending a restructuring of its capital structure). EBITDA therefore provides an indication of the profit attributable to all of the firm’s capital providers combined (lenders and investors) as it stands before interest.
- Tax: the level of tax paid is dependant on the tax jurisdictions in which a company operates and its capital structure. Excluding tax therefore enables a better assessment (for the purpose of comparison) of companies’ inherent ability to generate profit. For instance Company A may generate similar revenue to Company B and achieve equally as efficient cost management. However, Company A may report lower profit figures as a result of its tax bill. In addition, if Company B is financed primarily through debt, its tax bill may be lower as interest payments are tax deductible.
- Depreciation & Amortisation: excluded because these figures are fairly subjective from an accounting perspective. This is because there are different permitted methods of calculating depreciation and amortisation (for instance the straight line and reducing balance methods). The discretion afforded to accountants can therefore enable them to exercise this discretion in order to present companies in a more positive light. For this reason, it can be preferable to directly compare two firms if they are excluded.
When valuing Company A, investors may start by looking at the enterprise value (the market value of the equity and the net debt) of a similar company, for example Company B. They will divide Company B’s enterprise value by its EBITDA to calculate its EBITDA multiple; then multiply Company A’s EBITDA by Company B’s EBITDA multiple to estimate the enterprise value of Company A. For instance, if Company B’s enterprise value is £1million and its EBITDA is £100,000, its EBITDA multiple would be 10. If Company A’s EBITDA is £50,000, this would then be multiplied by 10 to give an estimated enterprise value of £500,000.
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By Jake Schogger - City Career Series