Distinguishing Enterprise Value (EV) From Equity Value

The distinction between a company’s EV, and equity value is an area of confusion. EV composed of a company’s permanent or long-term capital, which consists of a combination of debt and equity.

This invested equity and debt, comprises a company’s EV and represents funding to support a company’s growth and related assets. A company’s reasonable, proportional use of debt and equity to support its assets is a key indicator of balance sheet strength.

In a company’s capital structure, equity consists of a company’s common and preferred stock plus retained earnings which are reflected in the shareholders’ equity account.

Equity reflects the ownership held by the providers of equity capital, often referred to as ordinary shareholders. Ordinary shareholders generally have the right to elect directors to a company’s board, vote at the annual general meeting and approve the declaration of dividends.

EV, on the other hand, is the value of a business and reflects the value of its core operations to all providers of capital.

Various valuation techniques including discounted cash flow analysis or multiple based approaches (eg. EV/EBITDA, EV/EBIT) typically derive an estimate of EV. A challenge then arises in bridging from EV to equity value.

A potential buyer will normally estimate the EV of a target company and look to the most recent balance sheet to consider any required adjustment to arrive at the price to be paid for. Accounting book values are a good starting point to identify potential adjustments required.

Debt and other debt-like instruments are deducted from EV to arrive a equity value because equity holders have no claim on those sources of capital – these amounts reflect other stakeholders’ interest in the business.

As is the case for equity components that exhibit debt-like characteristics (ie, redeemable preferred stock), consideration should be given to the underlying nature of debt securities. For example, venture capital investors often fund portfolio companies using convertible debentures which are debt instruments convertible into equity if certain conditions are met.

Convertible debentures are legally defined as debt but are normally funded by shareholders and typically seek to protect investors from dilution. Thus practically, one often considers convertible debentures as equity and are not deducted from EV to arrive at equity value.

Other adjustments to bridge may include: working capital surplus or deficit; excess cash and surplus assets; minority interests; deferred tax assets / liabilities; long-term leases; and any pending lawsuits.

Value and final price paid is not only about DCF and multiples but also balance sheet acquired – an area addressed finally through negotiations. The journey to bridge EV to equity value could be long if information and data are not readily forthcoming.

It is, however, in the interest of both vendor and purchaser to arrive at mutually agreed price through an open, transparent process.

Reference: “Contemporary Valuation Issues in Deals”, ICAEW and KPMG (Best practice guideline 66).