Should we deduct cash / near cash from sum of equity and debt values to compute enterprise value? Should we add minority interests to market capitalization and debt value before deducting cash to arrive at enterprise value? These are some of the questions one often comes across.
Enterprise is defined as an organization created with a commercial intent and thus should be synonymous with a business firm. Enterprise value, then, should be synonymous with firm value. Firm value is the present value of the claims of all stake-holders against a firm. In a simple case where a firm is financed with only debt and equity, firm value is the value of debt and value of equity. If the firm has no non-operating assets, firm value can be valued by estimating future free cash flows and discounting those cash flows with an appropriate rate of return (which may vary from year to year) that embodies the returns required by creditors and shareholders of the firm. Since this is essentially the value of operations of the firm, if there is any non-operating assets, the value of such non-operating assets should be added to arrive at the firm value or enterprise value. (Copeland, Koller and Murrin have used enterprise value in this sense in their book)
In short enterprise value is the value shared by all investors, unlike debt value or equity value, which are shared only by creditors or by equity-holders respectively.
However, the term “enterprise value” has acquired a new meaning for last fifteen years or so. It is said to represent the minimum amount one would need for acquiring a firm, free of its debts. In this avatar it is often defined as:
a)Market value of equity + Market value of debt + Minority interests – Cash (Damodaran, see here)
b)Company's market capitalization - cash and cash equivalents + preferred stock + debt + minority interest (JP Morgan’s site, see here).
Investopedia, a popular website too computes EV as market cap plus debt, minority interest and preferred shares, minus total cash and cash equivalents. It explains why cash is deducted: “think of enterprise value as the theoretical takeover price. In the event of a buyout, an acquirer would have to take on the company's debt, but would pocket its cash.” See here. Intestopedia also defines another similar quantity called “Total Enterprise Value” or TEV as Market Capitalization + Interest Bearing Debt + Preferred Stock - Excess Cash. See here. Even this “total enterprise value” does not come close to what I have understood to mean enterprise value, i.e. the value of the firm. I will call the other definition of EV (mentioned above as a or b), as the trade definition. (It does not mean that all academics interpret EV as the firm value; I have seen a few scholarly papers where EV has been taken as what I have dubbed here as the trade definition.)
I am not comfortable with the trade definition, even if it is defined as the minimum amount that would be required to acquire a firm. My discomfort arises from two points:
1. First concerns deduction of cash. The logic given (by Investopedia for instance) that after acquisition this cash will be available for taking out presupposes that the cash is not needed for operations, in other words the operations of the firm do not need any cash and that cash can be removed without affecting the value of operation. This certainly can’t be true for any company. Some companies may have large amounts of “excess cash” i.e. cash balance over and above what is required for operations. This excess cash can of course be taken out without affecting operations but not the entire cash. Most companies may have some other non-operating assets albeit less liquid than cash. For example most (established) companies in India own excess land i.e. land not needed for operations. Will it be correct to remove the value such excess land may fetch in a distress sale? After all that value can be taken out from the company without affecting the operations at all once acquisition is complete.
2. The second point relates to adding minority interests. Minority interest is generally understood as a significant but non-controlling ownership in a business entity. Suppose the target firm (whose EV we are interested in) owns 20% of another firm, Z, that too is listed (for our convenience). Trade definition of EV implies that 20% of the market value of Z should get added to the market cap of the target. This pre-supposes that the market ignores the minority interest of the target in Z and thus the market cap of the target does not consider the value of its partial ownership of Z. I think this is being unjust to the market. In a reasonably efficient market minority interest should get reflected in the market capitalization; I however have no hard evidence for it. (I dare say we do not have any evidence to the contrary either i.e. the minority interest is NOT reflected in market capitalizations. There are, however, assertions that minority interests are valued at discount by market.)
In view of the foregoing I am convinced that the practice of adding minority interests and subtracting cash from market cap plus debt value of a firm for arriving at its EV is incorrect. To correctly determine EV one should first value the operations of the firm and then add to the value of operations so arrived all non-operating assets,including excess cash and minority interests.
Source: www.finance30.com
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