Business Valuation - In Theory and Practice

Enterprise Value

The term enterprise value (EV) is often used when discussing a company’s valuation. A common valuation multiple used is EV to EBITDA multiple. What is the enterprise value of a company and how is it applicable to private companies?

EV represents the total value of a company including both its equity and its debt. If we were to compare the value of a business to the value of a house, the EV would be the total value of the house. The equity that you have in the house is equal to the total value of the home, less any outstanding mortgage.

Math of EV

If you were looking at a public company and see that its market capitalization (share price times the number of outstanding shares) is $200M and it has total debt of $100M, then the EV of the company would be the sum of the two components or $300M. If the company generated $75M of trailing EBITDA, then its EV/ trailing EBITDA multiple would be 4X. If the company anticipates generating $100M in forward EBITDA, then its EV/ Forward EBITDA multiple would be 3X. This illustrates how the EV/EBITDA multiple can be easily manipulated by the EBITDA which is selected.

The enterprise value of a company that is being acquired is usually the same as the total purchase price. It would also drive the sources of uses of funds to complete the transaction since enough cash or cash equivalents would have to be raised to make up the entire EV. Suppose the purchase price of a company is agreed at $500 million. This would be its enterprise value. However, this company has $200M of debt on its balance sheet, so its equity value is $300M. The transaction could be structured using $100M injected by a private equity firm, $50M of rollover equity from the previous shareholders, $50M of vendor take back financing, $100 million in mezzanine debt, and the balance of $200 million in conventional bank financing. These would be the source of funds of which $400 million would be cash consideration (the private equity money, the mezzanine debt, and the senior debt), which would be used to pay the existing debt of $200 million leaving $200 million in cash for the seller plus the $50 million of equity rolled over, plus the $50 million in vendor take back. The seller would effective receive the $300M in equity calculated off the enterprise value (EV less debt) with the total funds raised to complete the transaction equaling the enterprise value.

When assessing the reasonability of a company’s EV, compare it against trailing EBITDA (as noted above), trailing EBIT, and net tangible net assets. It is particular important to compare the EV to net tangible assets. Tangible net assets would be defined as capital assets at fair market value plus current assets (excluding cash) less current liabilities. For capital intensive industries, it is important to watch the ratio of EV to tangible net assets since a high ratio would indicate that significant goodwill is being paid for the business. Then the question would be what supports this goodwill being paid? Why is the EV so much higher than tangible net asset?. It could be because this business has a patent on a specific product, or excellent customer relationships, or a barrier to a specific market. However, if you can’t properly define the source of the goodwill, then a high EV/tangible asset ratio could simply mean you are overpaying for the business.

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