So What Is This Enterprise Value?

Tan KW

Publish date: Tue, 01 Oct 2013, 12:12 AM

Posted by L. C. Chong on September 30, 2013

http://classicvalueinvestors.com/i/2010/03/so-what-is-this-enterprise-value/

Many investors rely on many different metrics such as the P/E ratio, price-to-book ratio, and price-to-sales ratio to determine whether a company is trading at a cheap price. Relying on these metrics may be misleading because it may make you buy something that is not as cheap as you previously thought it was, or it may make you might miss out on a buying to purchase something that you thought was too expensive, but really was not. So what exactly is the enterprise value? It is the price that you would have to pay to acquire a company free and clear. The enterprise value should really be called enterprise price because it has nothing to do with what the company is worth.

Let’s imagine that we are buying an apartment building for $1,000,000 that has a $700,000 mortgage and $300,000 in equity. In order to acquire the property free and clear, we would have to pay $1,000,000 with our money to pay off the $700,000 mortgage and the seller’s $300,000 in equity. In this case, the enterprise value (or enterprise price) would equal $1,000,000, which is equity ($300,000) plus debt ($700,000). In stock market terms, the $300,000 in equity that the seller wants would be equivalent to market capitalization, which is the price per share times the number of shares outstanding. From this example, we can construct a formula for the enterprise value in the following way:

Enterprise Value = Market Value of Equity (Market Capitalization) + Debt

This formula is almost complete, but it is missing one element. Let’s reuse the same example with the apartment property but incorporate cash into it. Imagine that we are buying the same apartment building for $1,000,000 with the same $700,000 mortgage and $300,000 in equity. But this time, in one of the apartment units, we find a briefcase with $200,000 in cash. What is the enterprise value, now?

Enterprise Value = Market Value of Equity ($300,000) + Debt ($700,000) – Cash ($200,000) = $800,000

By using the equation above, we can see that the enterprise value is not $1,000,000, but is $800,000, because technically, we only paid $800,000 after taking home the briefcase with $200,000. Therefore, the formula has to be adjusted to include EXCESS cash:

Enterprise Value = Market Value of Equity + Debt – Excess Cash

Notice that I said “excess” cash. In our example, the $200,000 is not really needed to operate the apartment building and therefore, is considered excess cash. When calculating the enterprise value, some investors use the entire cash balance that they find on the balance sheet. Using all the cash may lead to miscalculations because assuming that the company does not need to hold any cash to operate its business is not realistic. You only want to subract the cash that is truly not needed to operate the business. For example, I analyzed KSW Mechanical, whose balance sheet is shown below:

Source: KSW Mechanical 2009 10-K

To calculate the enterprise value, we need the following variables: the market value of equity, debt, and cash. The market value of equity is $24,000 ($24 million), which equals the March 19, 2010 closing price of $3.84 times 6,235,125, the number of oustanding shares. The debt is $1,112 which equals to $1,054, the long-term mortgage, plus $58, the current portion of the mortgage. The amount in cash is $14,783. Without separating cash into “necessary” and “excess” portions, the enterprise value is calculated in the following manner:

Enterprise Value = $24,000 + $1,112 – $14,783 = $10,329

To figure out how much of the $14,783 in cash is excess cash, it is useful to analyze current assets and liabilities. In our example, current assets are $37,719 and current liabilities are $18,632.

Source: KSW Mechanical 2009 10-K

If we subract all the cash from current assets, $22,936 in non-cash current assets remain. When we compare this to current liabilities of $18,632, we can conclude that we have enough current assets without cash to cover our short-term obligations under current liabilities, and therefore, none of the cash on the balance sheet is needed, and all of it can be considered excess cash. In this case, the enterprise value would be $10,329, as was previously calculated.

However, KSW Mechanical is a special case where it would be incorrect to treat all the cash on the balance sheet as excess. The company is in the HVAC contracting business, mainly in New York. On many construction projects, the contractor is required to get bonding that guarantees that the contractor will perform the obligation as spelled out in the bond. The bonding company can be an insurance company that will stand behind the contractor. For KSW Mechanical, the ability to get bonding is everything. If the company is not able to get bonding, it cannot get contracts, especially when the client is the government. The reason why KSW Mechanical holds so much cash on its balance sheet is to show the bonding companies that they are in good shape financially so that they can get bonding. When I called the management and asked what would happen to their ability to get bonding if they paid out this cash to shareholders through dividends or buyback, I was told that their ability to get bonding would deteriorate. As a result, I do not believe that all the cash that the company carries is excess cash, because if the company did not have it, then it would not be able to get the work that is necessary to operate their business. If the entire cash balance is not excess cash, then how much of it is? It is debatable.

Conclusion

The equation for the enterprise value is straighforward as repeated below:

Enterprise Value = Market Value of Equity + Debt – Excess Cash

The important part is to plug in the correct variables to get meaningful results. Most of the time, the excess cash can be determined by comparing current assets to current liabilities, but at other times, as with the case of KSW Mechanical, a phone call to the CFO may clarify how much cash is really excess.

http://lcchong.wordpress.com/2013/09/30/so-what-is-this-enterprise-value/

Discussions

2 people like this. Showing 18 of 18 comments

kcchongnz

Tan KW always posts good articles on fundamentals of companies. Here is another one written by LC Chong.

This article explain what is enterprise value, specifically market enterprise value, and what "excess cash" means and its relevance in valuing a company and its stock.

I agree fully that enterprise value is the right valuation metric rathan than market capitalization alone.

2013-10-01 05:38

lotsofmoney

Market value is highly variable.

2013-10-01 09:36

sense maker

Some listed companies have negative EV when it is traded below its net cash. This is typical for companies that hoard cash for ages and are stuck in unprofitable biz or drifting on without proper plan for biz expansion or investment. Can would-be acquirer buy those companies for free? Of course, not. So, while EV is a good measure of what an acquirer of the whole biz would pay in essence, it is not a general guide of right valuation by itself. :D

2013-10-01 10:06

kcchongnz

What I am saying is the right metrics in evaluate if the price is cheap or not is through using enterprise value, rather than market capitalization. This means rather than using PE ratio, it is more appropriate to use enterprise value/Ebit. this is because enterprise value takes into account of all the capital utilized to produce the Ebit for the whole firm.

Two similar company, one having net cash and no debt can have the same PE ratio as another having a lot of debt and no cash. However, if you look at from the angle of enterprise value/Ebit, they are totally different. Which one will you prefer to invest in?

By the way, could you tell me which are the companies in Bursa has a negative enterprise value? I know there are some in the US market.

Thank you.

2013-10-01 10:15

L. C. Chong

hello, i am not author of this article. I just forwarded other people wisdom. The source is stated at this first line.

2013-10-01 10:49

kcchongnz

LC, it is a good article to learn about enterprise value anyway. Ok now I know it is a foreign article (US?), I would like to add a couple of comments.

Enterprise Value = Market Value of Equity (Market Capitalization) + Debt

In Bursa, many companies have consolidated some subsidiary companies account into the main account. Hence we should add "minority interest" into the equation if there is any.

Secondly many companies also have things like "net profit from subsidiaries, jv" which is below the "operating income" in the income statement. This "net income" is not consolidated and hence is not part of its "ordinary business". The corresponding portions in the balance sheet such as "investment in subsidiary or jv" should be less of from the EV.

2013-10-01 11:09

sense maker

EV/ EBIT disregards financing and arguably is less complete. Some companies with good credit recrod pay much lower interest than others. The savings go to shareholders and should be included.

Each method serves some purposes and has its own limitations.

Net profit from subsidiaries will not show in a consolidated set of accounts. Share of profits from JV, associated companies will appear in consolidated accounts and I think they should be included in EV for the same reason MI is added to EV.

:D

2013-10-01 11:48

kcchongnz

EV/Ebit disregards financing? Ev includes market capitalization plus all debts (financing)as explained by the article.

Here is another article why enterprise value is a better comparable metric than market capitalization alone for companies with different capital structure.

http://www.magicdiligence.com/why-to-use-enterprise-value

A company in construction work with a small investment in say a ready-mix concrete plant will not consider the ready-mix concrete as its "ordinary" business. The gain/loss from its small investment will appear after the "operating profit" in the income statement. The portion of this small investment in the balance sheet is hence not part of its "enterprise value".

2013-10-01 13:25

sense maker

EV/ EBIT does not take into account interest expense in % which varies from company to company. This formula is good for valuation of biz as an enterprise and EBIT is useful as part of FCF in doing valuation of assets (which also excludes interest expense), but not for biz valuation for equity shareholders. I referred to the whole formula of EV/ EBIT, not just EV. :D

2013-10-01 15:14

kcchongnz

Lat us talk about valuation of a business. You want to buy a business. Let say you want to value the business you intending to buy. Which do you think is a better valuation method; PE ratio or EV/Ebit?

2013-10-01 15:35

sense maker

If you are buying a biz with a view to control it, the net impact post-acquisition on your cash flow and financing needs is best approximated by EV, of course.

If you are buying shares on KLSE as a minority shareholder, FCF to the equity shareholders (i.e. DCF) is best method.

EV and PE multiples methods are both short-cuts for quick references. We simply have to take into account interest and effective tax rates which vary from country to country, not least.

2013-10-01 16:55

kcchongnz

Ok let me be specific about the question I asked. There are two similar companies, A and B, doing the same business, both of them in Malaysia. Both shares are selling at $1.00 and they have the same number of shares outstanding, say 100m. So they have the same market capitalization of $100m. The difference is A has $50m of debts and $10m of excess cash, whereas B has a debt of $10m but an excess cash of $20m.

Company A B
No. of shares, m 100 100
Share price 1.00 1.00
Market Cap, m 100 100
Total debt, m 50 10
Excess cash, m 10 20
Book value, m 100 100

Further assume that both companies earn a net income of $10m as shown in the income statement below:

Company A B
EBIT, m 15.8 13.8
Interest, m -2.5 -0.5
EBT, m 13.3 13.3
Tax @ 25%, m -3.3 -3.3
Net income, m 10.0 10.0

So the ROE of A and B are the same as same at 10%, ie 10m/100m. The PE ratios are also the same at $1/10 sen, or 10.

Which company will you invest in? Note that they are selling at the same PE ratio.

2013-10-01 18:24

kcchongnz

Valuing a stock using discount cash flow either for the firm or equity shareholders alone, or using comparative methods such as PE ratio or EV/Ebit, both have their advantages or disadvantages. I myself use both methods but I am reluctant to say which method is better.

The former may appear to be the "right" method theoretically, but the major problem is the forecasting of its future cash flow. Nobody has a crystal ball for forecast. The later may be simplistic and subjective but that is most often used in the market place and acquisition by private equities etc.

2013-10-01 18:36

sense maker

Haha, of course, I will buy the one with lower entreprise value or enterprice price as the article already explained clearly.

Forecasting future cash flow is an inevitable part of acquiring a company as we buy a biz precisely for its future cash flow.

PE, EV/EBIT leave out important considerations that DCF captures. PE is easy but it does not adjust for the difference between future capex and future depreciation, as well as changes in working capital fund requirement.

Anyway, in practice, a small investor tends to use simplistic short-cuts because of the limited information we can access to about a company's future biz plan.

E.g Liihen.

It made RM1.20 EPS and paid RM0.40 DPS in the past 5 years from 2008 till 2012. If Liihen's next 5 years will be the same as the last 5 years, then PE is 6 times at RM1.42.

2008 and 2009 were crisis-hit years. If one should think that the furniture industry in Malaysia is run like a sunset industry (just like Homeritz, Poh Huat, etc) with little competitive advantage for Malaysian furniture makers on international scene and deserve a low PE of 6, then RM1.42 is fairly valued. However, if one believes the next 5 years will be (much) better profit-wise due to global recovery in demand for furniture, etc, the fair value will climb rather fast.

Ultimately, it boils down to how much you understand a biz, especially its competitive advantage, pricing power, its position in the industry, its prospect for sales expansion. This is what drives share price in the long run, and rightly so.

2013-10-01 19:28

kcchongnz

Posted by sense maker > Oct 1, 2013 07:28 PM | Report Abuse
Forecasting future cash flow is an inevitable part of acquiring a company as we buy a biz precisely for its future cash flow.
PE, EV/EBIT leave out important considerations that DCF captures. PE is easy but it does not adjust for the difference between future capex and future depreciation, as well as changes in working capital fund requirement.
Anyway, in practice, a small investor tends to use simplistic short-cuts because of the limited information we can access to about a company's future biz plan.

In US, the average 24-month forecast error is 93%, 12-month, 47% from 2001-2006 (SG Global Strategy Research). There are too many variables; the economy, the path of interest rates, the sectors, the particular stocks, sales, costs, taxes, capex, change in working capital, D&A etc.

Hence forecasting future cash flows and then discount them back to find the present value of a business, though elegantly done and theoretically correct, is full of uncertainties.

You will be surprise in the real world, most acquisitions and purchases are carried out through enterprise value and price-to-book. Even in academic studies, the predictability of future stock prices is also not so significantly from the discount cash flow analysis, but more from what you consider as simplistic like price-to-book and EV/Ebit. These types of things you can Google or search for academic studies.

2013-10-02 10:24

sense maker

In any major acquisition of a controlling stake, a due dilligence is typically carried out with DCF as a base for the financial part. Invariably, it started using inputs from the financial projection prepared by the company in question and then moderated and finalised between the buyer and seller, with their respective financial consultants in attendance.

EBITDA multiples, PE multiples, and other earnings method can be calculated easily if based on historical data. Historical information however serve just as a base as future may be very different depending on the company's biz in quesiton. So they will be more useful if based on future data.

You see, if you just use historical earnings multiple to negotiate, the negotiation would be too superficial and cannot really cover all angles to protect yourself as the acquirer. Seller may want 8 times EBITDA but buyer offer 6 times. It is hard to bargin meaningfully without zooming in on details in practice.

Price to book is more suited for banks and companies with assets that can be easily deconsolidated or disposed of separately, especially now that FV accounting has been used.

:D

2013-10-02 12:56

kcchongnz

So what if the seller or his consultant say his business can grow at 20% for the next 5 years but the buyer and his consultant say from their crystal ball, the business would be stagnant at best?

2013-10-02 13:28

sense maker

Haha, then, they have to settle at somewhere in between. A lot depends on who is more desperate to do the deal in real life's negotiation, as with all things in life.

2013-10-02 13:33

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