Enterprise Value (EV) - Calculation, Multiple and Precautions!

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Contents:

1. Enterprise value (EV).
2. EV Multiple.
3. Precautions.

"If you know what Enterprise Value (EV) is and how to calculate Enterprise Value (EV) and EV Multiple, skip to point 3 - Precautions."

1. Enterprise Value (EV):

What is Enterprise Value (EV)?

Enterprise Value (EV) is the measure of a company's total market value i.e., it is the effective cost of buying a company or the theoretical price of a target company (before a takeover premium is considered). It is also known as the size of the business.

How is Enterprise Value (EV) calculated?

Simple formula:

EV = Market Capitalization + Market Value of Debt - Cash and Cash equivalents ........................Equation - 1

Derivation of Equation - 1 formula for better understanding:

Assets = Liabilities + Equity ........................Equation - 2

Operating Assets + Non-operating Assets = Operating Liabilities + Financial Liabilities + Equity

Operating Assets - Operating Liabilities = Equity + Financial Liabilities - Non-operating Assets* ......................Equation - 3

Hence, Enterprise Value (EV) can also be termed as the value of operations of a business.

Extended Version of formula:

EV = Market Capitalization (of all types of shares) + Market Value of Debt + Non-controlling Interest* - Non-operating Assets*

* Non-operating Assets and Non-controlling interest plays a crucial role in EV calculation and its role is discussed in below sections.

2. EV Multiple:

EV Multiple is the most sought-after metric that analysts look for, while valuing a business. But why is it so?

Because EV Multiple takes care about the comparability of the businesses as each one of them are of different sizes. But how?

As we know despite businesses operating in the same sector or industry they are of different sizes and capital structure and due to this, comparability issue arises. We cannot measure whether a company having EV of ?1,32,000 crores worth more or a company having EV of ?1,00,000 crores worth more. To cope up with this issue, we neutralize the size of the business.

And for neutralizing it, we need a common denominator. And this denominator can be EBITDA, SALES, EBITDAR, etc.

How it neutralizes Enterprise Value and make it comparable?

For example,

ABC Co.

EV = ?1,10,000 crores

EBITDA = ?19,000 crores

EV/EBITDA = 6.95x

XYZ Co.

EV = ?1,32,000 crores

EBITDA = ?14,000 crores

EV/EBITDA = 7.86x

As discussed above, we cannot tell which company have more worth by just evaluating the enterprise value. And when we neutralize it, we observe that, ABC Co. and XYZ Co. have worth of 6.95 times and 7.86 times of their EBITDAs respectively. The resulting neutralized metric is called multiple and is making Enterprise Value (EV) comparable.

NOTE: For comparability, make sure each company follows the same GAAP, and if not, the metrics should be adjusted on the basis of your target company which you are valuing. And also, the period of financial statements should also be the same or LTM.

REMEMBER: EBITDA, EBIT, EBT are Non-IFRS/Non-USGAAP defined metrics whereas Gross profit and Net Income are IFRS/USGAAP defined metrics. Therefore, you should be careful about this, because every company could calculate these metrics a different way, so you should check those calculations yourselves.

3. Precautions:

Equation - 1 shows what it would cost to own the company, free and clear of all debt, and is the Enterprise Value (EV) of the company.

But can we take that Enterprise Value (EV) in calculation of EV Multiple?

"Yeah, but some precautions have to be kept in mind while calculating Enterprise Value (EV) using Equation - 1."

Why?

Because, if you don't take precautions, Enterprise Value (EV) in Equation - 1 will not depict the true Enterprise Value (EV) and due to this, there will be lack of consistency in the numerator and denominator of the EV Multiple and deteriorate the result of this metric.

And this lack of consistency is due to Two metrics: Non-controlling Interest and Non-operating Assets.

That's why, precautions should be taken with these metrics while calculating the EV Multiple during Valuation.

To understand this, first, we have to understand what Non-controlling Interest and Non-operating Assets are.

Non-Controlling Interest: Non-controlling Interest is created when a company owns greater than 50%, but not 100% of a subsidiary. Since, the company effectively controls the subsidiary, the company will prepare fully consolidated financial statements.

Company owning less than 50% of the subsidiary implement either cost method (20% or less) or the equity method (above 20% & below 50%). Hence it is not required to prepare the fully consolidated financial statements and also not required to show non-controlling interest.

EV Multiple and Non-controlling Interest Relationship:

If a company is having non-controlling interest, then, subsidiary is fully consolidated with the parent company and parent company will prepare the fully consolidated financial statements.

Let's say, a parent company own's 75% of a subsidiary.

So, while calculating EV Multiple, we encountered an error, that, parent company's EBITDA is now reflecting 100% of subsidiary's EBITDA (because it is fully consolidated) but only 75% of Subsidiary is reflected in the Enterprise Value (EV) of the parent company.

To cope up with this error, we should add 25% of subsidiary i.e., non-controlling interest to the Enterprise Value (EV) so that numerator and denominator reflect 100% of the subsidiary. Consistency.

Non-operating Assets: Non-operating Assets are assets that are not required in the normal operations of a business but can generate income, nonetheless. For example, excess cash and cash equivalents, marketable securities, assets held-for-sale net of its liabilities, loan receivables, Investments in unconsolidated affiliates (less than 50% ownership), etc.

EV Multiple and Non-operating assets Relationship:

Let's say, a company have 20% of Non-operating Assets.

So, while calculating EV Multiple, we encountered an error, that, Enterprise Value (EV) is reflecting 20% of Non-operating Assets, but EBITDA is reflecting 0% of Non-operating Income and expenses, because non-operating income and expenses are shown below EBITDA in Income statement and hence EBITDA does not include non-operating income and expenses.

To cope up with this error, we should subtract 20% of non-operating assets from the Enterprise Value (EV) so that numerator and denominator reflect 0% of non-operating assets and Non-operating Income and expenses respectively. Consistency.

NOTE: Equation - 1 is not wrong, it is just you have to be cautious about calculating Enterprise Value (EV) using Equation - 1, because in this equation Market capitalization and Cash and cash equivalents impliedly includes Non-controlling Interest and Non-operating Assets respectively. Because if you do not take these two metrics into account while using Equation - 1, then Equation - 2 will not balance which is the basis of accounting and hence will not represent the true Enterprise Value (EV) i.e., value of its operations.

So next time, be cautious while calculating Enterprise Value (EV).

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Author: Mohit Bhatnagar, FMVA?

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