Talk:Enterprise value

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[edit] Rewrite

The edition I overwrote included a lot about how EV is 'correct' or 'better'. It isn't. It measures a different thing. There was also stuff about how it measures a take over value. This is very wrong. While it might be used by someone buying just the assets (who would then apply their own cost of capital and taxes onto it), it will never be a takeover value because it ADDS the debt value. You never pay MORE for privilege of assuming debt. Retail Investor 18:57, 25 November 2006 (UTC)

Enterprise value is very relevant to takeover discussions. It represents all the financial stakeholders--if you ignore the value of a firm's debt you could be ignoring a very significant portion of its capitalization. It doesn't imply that you "pay more for the privilege of assuming debt." For example, if a company had a equity value of $10 and debt of $10, its EV is $20. If you took over the company by buying all of the equity, you will assume all the debt and thus part of the consideration paid is the $10 in debt assumed. In some cases, a buyer will want to recapitalize the company. If you wanted the new capital structure to be debt-free, you'd have to buy out all the debtholders, and again using the above example the total value would be the $10 in equity and $10 in debt.
You misunderstand my comment because you did not review what I had deleted. It used to say EV was the "theoretical takeover price". To use your example, it said the common equity was worth $10+$10=$20. And if the debt was $30, then the common equity stake would be worth $40. That was obviously wrong. I don't disagree the metric is 'relevant'.

[edit] I disagree with cash in equation

I deleted the reference to cash in the equation, because the value of cash is already included in the market value of the common equity.Retail Investor 18:57, 25 November 2006 (UTC)

Right, which is why excess cash is subtracted from the value. This is a necessary step when coming up with a capital structure-neutral measure of valuation. mullacc 00:41, 30 November 2006 (UTC)

I don't agree. Cash is an asset like any other. EV measures the market value of the assets. Those assets are owned (and valued) by the long-term debt and equity owners. EV measures the total.

I've never thought of it as a "market value of the assets", but rather the market value of the on-going enterprise. Unlike other assets, cash (beyond a small amount needed for operations) is not essential to operations.

If EV doesn't value the total of assets. And it doesn't measure the market value of all owners, what DOES it measure? Why would one define 'on-going' as everything but cash?

And when doing an "apples-to-apples" comparison to similar companies with different capital structures/cash balances, it is essential to take cash out of the picture.

Why? You normalize for the capital structure, not the assets.

Consider two companies with exactly the same balance sheet except the second has excess cash of $10,000. The market value of their debt will be exactly the same. The market value of the common equity will be $10,000 higher for the second company. Your equation says that the EV of both is the same. Why on earth? The second has $10,000 more assets. Why is it not worth $10,000 more?

Because cash is just a component of the company's capitalization. If the company took that extra $10,000 in cash and paid down debt or paid a dividend to shareholders, its EV would not change but its equity value would. Since EV is a capital structure neutral methodology, the company with the excess cash should have the same EV and EV/EBITDA multiple as the other company. In this sense, excess cash is simply an opportunity to pay down debt, pay a dividend or buy back equity--all capital structure considerations.

And that dividend makes the second company worth more before the payment than after it has been paid out. Cash is an asset, not 'a component of capitalization'. Capitalization is about who OWNS the assets. It has nothing to do with the assets themselves.

Here is a practical example: a public company is being taken private by a private equity firm who will be using a significant amount of debt to purchase the company. Let's say a company has $10 in equity value, $10 in debt, $5 in cash and $3 in LTM EBITDA. Let's assume the purchase price is equal to market value and the PE firm will take out the existing debt. The total enterprise value will only be $15 because the $5 in cash will be used to paydown the debt ($10 of equity + $10 of debt - $5 of cash).

This example doesn't prove anything. There is only one company. The point of EV is to normalize between two different companies. My example above proves the second company is more valuable, because the new owners of it could take a $10,000 dividend. AND they would still have the company

I think the logic of the equation can stand on its own, but it also happens to be common practice in professional usage. Corporate finances texts subtract cash and private equity, equity research and M&A folks also use the same methodology. If necessary, I can point you to SEC S-4 filings where investment banks calculated EV as part of their fairness opinion. A look at some equity research reports should also show the same result.

Quoting someone else is no argument. If you are an investor, you know that "fainess opinions" are anything but fair.


[edit] The EV/EBITDA multiple

The phrase "EV/EBITDA measures the payback period of the whole capital structure" is incorrect, or at least unclear. It cannot represent any sort of "payback" because EBITDA leaves out, among other things, significant cash flow items such as capital expenditures and changes in working capital. I'm going to revert back to my language on EV/EBITDA because I think it points out the more relevant information and I think the comparison to P/E multiples is helpful. The language could use be more concise though, so I'm open to those type of edits. I also made some formatting changes to the formula. mullacc 00:41, 30 November 2006 (UTC)

I don't agree with any of that either. Retail Investor 22:39, 1 December 2006 (UTC)

Well, it'd be helpful if you explained what you meant by a payback period.

Why did you decide it was wrong if you didn't know what it is? When a value is devided by a measure 'per year', the result is pure math - a number of years. The other stuff you talk about is really about "free cash flow" that is a measure pertainent to common share holders only - not debtholders. You are way off topic.
I decided it was wrong because it is nonsensical. When people use EV/EBITDA, it is almost always for purposes of valuing the equity. Debtholders are more likely to worry about Debt/EBITDA and Debt/Equity ratios. You said "EV/EBITDA measures the payback period of the whole capital structure"--I understand what you're trying to get at, but this notion of payback periods is more relevant to P/E ratios where all of earnings are in some way claimed by equity holders. But you cannot make this same statement with EBITDA because a company will be spending cash on a handful of others things (capex, taxes, interest, changes in working capital, etc) before debt principal can theoretically be paid or before equity-holders can lay claim to anything. There is certainly a place for proper discussion of payback periods, but it is probably under value investing for the equity side and credit analysis for the debt side--to put it here just confuses the nature of EV and EV/EBITDA.mullacc 05:45, 2 December 2006 (UTC)

[edit] 11/30 Responses

Retail Investor writes: Why? You normalize for the capital structure, not the assets.

Right. And the excess cash causes the capital structure to be other than normal.mullacc 00:31, 1 December 2006 (UTC)

Retail Investor writes: And that dividend makes the second company worth more before the payment than after it has been paid out.

You're talking about equity value. You're right, but that has nothing to do with EV.mullacc 00:31, 1 December 2006 (UTC)

Retail Investor writes: Capitalization is about who OWNS the assets. It has nothing to do with the assets themselves.

Capitalization is about how the assets are funded. Equity is about who owns the assets. Why would you increase capitalization to fund excess cash on the balance sheet? You wouldn't and that's why investors demand stock buy-backs or dividends when a company stockpiles too much cash. And when you do financial analysis, you assume that this is how the cash would be treated in case of a buyout--hence the subtraction of cash in the equation of EV.mullacc 00:31, 1 December 2006 (UTC)

Retail Investor writes: My example above proves the second company is more valuable, because the new owners of it could take a $10,000 dividend. AND they would still have the company

This is exactly what my example shows. If your example company had an equity value of $100,000 and no debt, and a buyer came along and bought the whole thing at market value, he'd pay $100,000 and then immediately take out the $10,000 in excess cash. So how much did he really pay for the company? $90,000. If your company had $50,000 in equity value and $50,000 in debt, the buyer would pay $50,000 to the equity holders, and then use the $10,000 of excess cash along with $40,000 of his own money to pay down the debt--again, the total paid for the company is $90,000. Let's say this company used the $10,000 to buyback stock at market value--then it would have equity value of $90,000 after the buyback and $0 in cash, but is the company worth any less as an on-going entity than before? Of course not.

Retail Investor writes: Quoting someone else is no argument. If you are an investor, you know that "fainess opinions" are anything but fair.

I'm a professional investor and I've been an investment banker and I've been a finance student. Everyone in those worlds agrees on the EV equation as I have laid it out. Whatever you think about the integrity of fairness opinions is irrelevant, it's simply an example of a professional application of an industry standard metric. You may not agree with the metric and that's fine, but Wikipedia should reflect the accepted academic and professional equation and not your opinion. Have you spent any time looking at the various financial glossaries available on the web? The external link on this entry agrees with my equation, as does the Reuters glossary.

You still have not disproved my simple example. Adding all kinds of extraneous stuff only confuses matters. The company with the additional $10,000 cash is worth $10,000 more than the company without. Cash is an asset like any other asset. Assets do not determine capital structure. If you sold out to some private-equity buyout at a price determined by a 'fair-value' opinion that discounted the value of the cash on the balance sheet, I'm sorry for your loss. You got hoodwinked. The first lesson of investing is to think for yourself.Retail Investor 22:52, 1 December 2006 (UTC)
I did disprove it; see just a few lines above with the paragraph that starts "This is exactly what my example shows." And you're continuing to conflate equity value with enterprise value. When you say "The company with the additional $10,000 cash is worth $10,000 more than the company without", you'd be right if you meant equity value--yes, the market cap will be higher--but you have a fundamental misunderstanding of capital structures if you think enterprise value will be higher.
"Assets do not determine capital structure." Well, Assets = Liabilities + Equity, so, in a sense, the amount of assets a company owns will determine its total capitalization, or visa versa.
And no, I haven't been hood-winked by a private-equity buyout. I am the private-equity buyer.mullacc 05:04, 2 December 2006 (UTC)

[edit] Other opinions

On looking at this page and the discussion above, I can see two clear sources that support a definition that includes subtracting cash. Remember that Wikipedia is not a place for original research. If you want to argue that EV does not subtract cash, you need to provide a reliable source to support your definition, not thought experiments. Grouse 11:10, 2 December 2006 (UTC)

Why can't we be more inclusive? If I say 2+2=4, why should I be deleted because I cannot quote it?Lesliejane 19:36, 4 December 2006 (UTC)
The No original research policy is one of the core content policies of Wikipedia. If you want to discuss it, I suggest you do it on the talk page for the article. Grouse 19:45, 4 December 2006 (UTC)

[edit] Response to 12/4 changes

I made a few changes to the opening paragraph (which I will detail below), but I left the rest alone despite problems I will lay out here.

Enterprise Value measures the total cost to buy all of a business and payoff all its debts in the process.

I think this is somewhat redundant--the opening statement states that EV represents that aggregate of all financing sources. I think that's enough. To explicitly say that it's the cost to buy all of a business and pay off the debts ignores the realities of takeover premiums and call premiums on the debt.

It is a useful way to compare companies with different capital structures. It normalizes the different costs and different risks associated with different capital structures.

The emphasis on normalizing costs and risks feels too strong to me. I think we should leave it at the idea of normalizing for different capital structures and let the capital structure article spell out the reasons why risks/cost are different under different scenarios.

Metrics using EV

  • EV/EBITDA as a measure of payback period: I still don't understand this and have never seen it used this way. As I said above, EBITDA excludes many items that need to be paid before anyone is "paid back." If two companies both trade at 5x EBITDA but one has $5 million in capital expenditures and the other has $50 million, how can anyone say these companies have the same "payback period"? Now, P/E ratios DO imply a payback period to equity holders (or, more accurately, an expected rate of return) and since EBITDA measures a company's ability to generate cash from operations, the two are related. I'd change this section to something like: "EV/EBITDA is a multiple used to help value the equity of a company, often in conjunction with other metrics such as P/E multiples. " I'd like to see sources on the notion of payback periods and EV/EBITDA if we are going to include it--I've done plenty of valuation work and credit analysis in my day and I never used this metric for that purpose.
  • EBITDA/EV is the metric most used to measure the cash rate of return on the investment: This is pretty confusing. It's just the inverse of the above ratio and thus suffers from similar problems. Any sources for this usage?

I'd also add a quick statement on the use of EV versus equity value/market cap/price in multiples. This is what I was trying to get at with my statement about P/E multiples in the early version. Something like: "When calculating various multiples related to the valuation of a company, EV is appropriate to use when the denominator incorporates items that do not reflect capital structure (e.g. EV/EBITDA, EV/EBIT, EV/Sales, EV/Unlevered Free Cash Flow) while price or equity value is appropriate for items that do (such as P/E, price/book value and price/levered free cash flow)."

EV is used by

I'd eliminate this section. By mentioning the use of EV in valuation metrics, it becomes obvious that stock market investors use EV. And the section on buyers of controlling interests should be eliminated for the same reasons I gave for removing references to "takeover" from the intro paragraph. I do think it is important to mention takeovers at some point in this article--but it needs to be worded careful. Perhaps something like this placed under the formula: "EV represents the theoretical takeover value of a company at current market value--a theoretical buyer desiring to re-capitalize the company would need to fund both the purchase of equity and the redemption of the debt outstanding, while making use of excess cash on the balance sheet. An actual takeover may or may not include the redemption of debt outstanding and would likely include a premium to equity and various transaction costs."

And to the point made about using only market value of debt versus book value: In practice, book value is used quite often. The exception would include distressed situations where bonds are trading at severe discounts to par. In reality, if a company decided to pay off the entirety of its debt, it would probably need to call that debt rather than attempt to purchase it on the open market. Call provisions are usually at 100% of par or greater. Just going out on the market to buy up your debt is an expensive proceeding and would be detected quickly by bond market participants--but sometimes companies do conduct tender offers when their bonds are trading at heavy discounts and there is a good chance bondholders will sell for something significantly less than par. So, in the vast majority of situations, it is appropriate to use the book value of debt. As with all things in finance, never use EV blindly--check to make sure you aren't dealing with a distressed situation.

Subtracting cash in the equation

The "alternate" calculation is no alternative, it's just wrong. If a reputable source can be found, I'd reconsider.

common equity at market capitalization

I changed this back to equity value. Equity value is slightly different than market capitalization--equity value includes market cap. Market cap alone is wrong in this case.mullacc 18:34, 5 December 2006 (UTC)

[edit] Removed original research

As there has been no attempt to supply a source so far, I have removed this bit from the article:

The alternate calculation of EV does not subtract cash. [original research?] From this POV, the EV of a business with excess cash is higher than that of the exact same business without the cash. Any buyer of the first business should pay more money in exchange for receiving cash back as a dividend. Value is transfered from the business to the buyer's pocket.

Please do not add it back to the article without providing a source. Grouse 14:05, 5 December 2006 (UTC)

[edit] Fair use rationale for Image:Pyat rublei 1997.jpg

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[edit] Connection between EV and Terminal Value?

On the page for Terminal Value ("http://en.wikipedia.org/wiki/Terminal_value_(finance)") the last word in the section about "Perpetuity Growth Model" the term "Enterprise value" is stated. It's linked to this page. However, the definitions of Enterprise value on that page and on this page seem to be totally different. Why? Perhaps the term Enterprise value has two totally different meanings and currently only one of them is stated on this page. Or, am I missing something? --Smallchanges 15:44, 1 August 2007 (UTC)

[edit] Usage

This is unclear: "Stock market investors use EBITDA/EV to compare returns between equivalent companies on a risk adjusted basis. They can then super-impose their own choice of personal debt levels. In practice, stock investors cannot use EV because they have no access to the market values of the company debt.

This is POV: "It is not sufficient to substitute the book value of the debt because a) the market interest rates may have changed, and b) the market's perception of the risk of the loan may have changed since the debt was issued. This isn un-encyclopedic: "Remember, the point of EV is to neutralize the different risks, and costs of different capital structures. —Preceding unsigned comment added by 59.14.209.55 (talk) 06:56, 4 November 2007 (UTC)