When you start to learn business valuation, you start to hear a range of different ‘values’ that a business can have. Book value, market value, equity value, enterprise value. Which one should we use? Which one should I pay attention to?
That’s what I am going to try to explain in this blog post. I’ll start with some textbook definitions, so that you can reference them later.
Enterprise Value: The value of the business’ operations
Equity Value: The value of the business’ assets, net of liabilities
Note: When talking about equity value, book value mean as it is shown in the financial statements or ‘books’ while market value refers to the value of the business’ stock. Obviously, for a private business with no stock, market value is irrelevant.
So, what is the difference between equity value and enterprise value? We can start to get an idea by looking at the following equation:
Equity Value = Enterprise Value – Net Debt
The biggest difference here, is debt. Remember our definition for enterprise value is the value of the business’ operations. If a business is entirely funded by debt, then it won’t operate without it, and the value of the operations must be zero. However, I prefer a different way of calculating enterprise value, as it shows us better how it actually works. I like using the following formula:
Enterprise Value = Operating Assets – Operating Liabilities
So, to use this formula we need to define what our operating assets and liabilities are. This can be tricky, as it depends on the business and what the business does, but in general the operating assets and liabilites are those that are actively used in creating revenue. As a rule of thumb, anything that would show up related to the ‘cash from operations’ on the Cash Flow Statement, could be considered an operating asset. The big caveat, is that we don’t include cash. Things like inventory, accounts payable and PP&E should be included.
So, our enterprise value shows the value of the assets that make us money, less any liabilities that are involved in making us money. However, this also leaves the leverage of the business in our value. We can see how big the business is using enterprise value. Let’s consider the following example of a business.
Enterprise Value: $900m
Our Net Debt here, would therefore be $450m. If we use our formula for Equity Value above, we get the following:
Equity Value = $900m – $450m = $450m
So, if we just took the market capitalisation on this business, which has a debt to equity ratio of 1.1, we would see a business that is half the size of what it’s operations can actually achieve.
As a side note, this can show that debt is not the most evil thing in the world, as it allows the business to grow by using a more secured form of funding.
So, which one should we use when valuing a business or it’s stock? Theoretically, the value of a business’ stock should be the value of it’s equity. However, a disconnect appears when you think about buying the stock of the business as buying an ownership stake.
Take this example. Company A has $500k equity and $500k net debt (EV of $1mil). Company B wants to buy Company A. How much should they pay? If they buy all of the stock, and own the company, they will be responsible for the debt. The $500k debt that Company A had on its balance sheet will need to be refinanced. So, a part of the purchase price will have to be this debt.
This shows you the disconnect. To buy the stock, if it is trading at par, you would pay $500k. However, if you did this you would automatically on the hook for double that. Now, to be more realistic, we have to look what the stock is actually trading at. Let’s assume it is trading at $600k. Now, the total purchase price will be $1.1m. However, when buying a company, you must almost always pay a premium. This premium accounts for synergies that might be created by the merger. So, let’s say you actually pay $750k for the stock. Now your purchase price is up to $1.25m.
So this creates a disconnect between the stock price and the price of the company. Even taking out any premium that might be paid, there has to be some consideration of the leverage of the business in the stock price. So and understanding of both what the equity value represents and what the enterprise value represent, and how they fit together, is important for understanding how a stock is priced.