Both business valuation and stock market valuation are used to value a company during mergers and acquisitions. Most business owners planning an exit do not know that each method offers a slightly different perspective. To differentiate between them, it is important to understand how they differ to ensure that you consistently calculate free cash flows and discount rates.
Understanding the Difference Between Equity and Enterprise Value
Enterprise value (EV) equals equity value (QV) plus net debt (ND). Net debt is debt and equivalents minus cash. Here’s the formula:
EV = QV + ND.
Let’s use the value of a house as an example. Suppose you decide to buy a home for $700,000 and make a down payment of $200,000. You borrow the remaining $500,000 from a lender.
So, $700,000 (the entire value of the house) is the enterprise value, and $200,000 (the value of your equity in the house) is the equity value. Let’s apply the formula:
$700,000 (the value for all the contributors of capital) = $200,000 (You) + $500,000 (Lender).
Adding debt and subtracting cash to the formula EV = QV + ND does not increase enterprise value.
Let’s consider the same example. Suppose you borrow an additional $100,000 from the lender. Now you have $100,000 more in cash as well as in debt.
$700,000 (EV) = $200,000 (QV) + $500,000 + $100,000 – $100,000 (ND)
The additional $100,000 in the bank account does not increase the value of the house (EV).
But what if you use the additional cash to make improvements to the house? Would that increase the EV (value of the home)?
Let’s assume that you increase the house’s value by $100,000 after making improvements worth $100,000. So, EV increases by $100,000 while QV remains unchanged. When you sell the home, you get $800,000. You repay $600,000 to the lender and pocket your QV of $200,000.
$700,000 + $100,000 (EV) = $200,000 (QV) + $500,000 + $100,000 (ND)
Understand that EV need not increase in proportion to improvement spend? As EV is a function of future cash flow, the value of the house may increase much higher than the investment in improvements.
Suppose, by spending $100,000 on home improvements, you get a sales value of $850,000, and the value of the house increases by $150,000. After selling the house for $850,000, you can pocket $250,000 (QV) after paying the lender.
$700,000 + $150,000 (EV) = $250,000 (QV) + $500,000 + $100,000 (ND)
However, if the value of the house increases only by $50,000 after spending $100,000 on improvements, you pocket only $150,000 (QV) after paying the lender.
$700,000 + $50,000 (EV) = $150,000 (QV) + $500,000 + $100,000 (ND)
In other words, enterprise value represents the value of a company’s core business operations. It’s available to all shareholders, including those holding debt, equity, preferred, and other forms of financial instruments. On the contrary, equity value represents the total value of a company, which is available only to the equity shareholders.
What Is Enterprise or Business Value?
As the capital structure doesn’t affect the value of a firm, analysts use enterprise value to know the worth of a business when comparing firms with different capital structures. When someone buys a company, he has to acquire both the company’s debt and cash. However, the company’s cost increases when acquiring the debt and decreases when acquiring the cash.
Business value is calculated as the difference between operating assets and operating liabilities for all investors, such as equity, preferred, debt, etc. In other words, enterprise value is calculated by adding market capitalization plus all the company’s obligations, including interest due to shareholders, preferred shares, and whatever else the company owes. Analysts usually subtract any cash or cash equivalents that the business currently holds to get the enterprise value.
To calculate enterprise value from equity value, add minority interest, debt, and preferred shares, and subtract cash and cash equivalents. Cash and cash equivalents are the core assets of a business and are not invested.
Depending on the analyst’s judgment and the extent of liquidity of the securities, short-term and long-term investments are also subtracted in most cases. Items such as debt, preferred stock, and minority interest are added, representing the amount due to other investor groups. These items need to be added back as enterprise value is available to all shareholders.
Enterprise Value (EV) = Equity Value (QV) + Debt + Preferred Stock + Non-Controlling Interest – Cash and Cash Equivalents
What Is Equity or Stock Market Value?
Equity value (QV) is the difference between total assets and liabilities and is calculated for equity shareholders.
In other words, equity value (QV) represents the value of the company’s shares and the loans taken by the business from the shareholders. The calculation for equity value (QV) adds enterprise value (EV) to non-operating assets, then subtracts the debt net of cash available. You can break down the total equity value (QV) into the value of shareholders’ loans and outstanding common and preferred shares.
To calculate equity value, multiply the share price of the company by its number of outstanding shares.
Equity Value (QV) = Price of a Share * Number of Outstanding Company Shares
Another way to calculate equity value (QV) from enterprise value (EV) is by subtracting debt and debt equivalents, non-controlling interest, and preferred stock, then adding cash and cash equivalents. Equity value (QV) concerns what is available to the equity shareholders of a company. As debt and debt equivalents, preferred stock, and non-controlling interest represent the share of other shareholders, they are subtracted. Cash and cash equivalents are added as any cash left after paying off other shareholders are available to equity shareholders.
Equity Value (QV) = Enterprise Value (EV)- Debt and Debt Equivalents – Non-Controlling Interest – Preferred Stock + Cash and Cash Equivalents
When to Use Equity Value and Enterprise Value?
Enterprise value (EV) is used to value all kinds of businesses, except a few sectors like banking and insurance, where only equity value (QV) is used. However, it is crucial to know whether we should use EV or QV in a particular scenario. The metric used to value a business is the deciding factor for enterprise value or equity value.
Use equity value (QV) if the metric used for valuation includes interest income, the net change in debt, and expenses. You can use enterprise value (EV) if the metric consists of costs, the net change in debt, and interest income. You can use enterprise value (EV).
Use enterprise value before the deduction of debt because both debt and equity shareholders are entitled to that cash flow.
How to Calculate Discount Rates Using Equity Value and Enterprise Value
The calculation of QV (equity value) concerns only what is left for the equity shareholders. Therefore, you need to discount the cash flow available to equity shareholders by the cost of equity.
On the other hand, enterprise value is what is available to all the investors in the company. To calculate enterprise value, discount the cash flow available to all the shareholders by the weighted average cost of capital.
Both methods, business valuation (enterprise value) and stock market valuation (equity value), play a crucial role in the valuation of businesses. Understand when to use which method to conduct the valuation process effectively and get reliable outcomes.