Introduction

In the context of an interview, questions about Equity Value and Enterprise Value are common as they are the first building block of valuation.

These questions range across various levels of complexity, from basic concepts to advanced scenarios:

• Basic: For example, understanding the difference between Equity Value and Enterprise Value.

• ‍Intermediate: Such as explaining why you subtract cash when calculating Enterprise Value.

• Advanced: Including complex questions like determining the fully diluted shares outstanding when a company has multiple classes of convertible securities.

Demonstrating a solid grasp of these questions not only shows your technical knowledge but also your analytical thinking and problem-solving skills, which are crucial for a career in investment banking.

Equity Value

Equity Value represents the value of a company that is attributable to its shareholders. Its calculation might vary depending on (i) whether you are considering book value or market value, and (ii) whether you are considering basic shares or fully diluted shares outstanding.

Book Value vs. Market Value

Book Value

Is the value of a company's equity as reported on the balance sheet. This represents what investors would theoretically receive if the company were liquidated, selling all its assets and paying off all its debts. It is calculated as:‍

Formula: Shareholder’s Equity = Total Assets - Total Liabilities

Market Value

Represents the value of a company according to the stock market. It is calculated as:‍

Formula: Market Cap = Share Price x Number of Shares Outstanding (NOSH)

Book Value and Market Value can often differ significantly due to various factors:

• Book Value greater than Market Value: This situation indicates that the market has lost confidence in the company, often due to business problems, lawsuits, or economic conditions. Value investors might see this as an opportunity to buy undervalued stocks.

• ‍Market Value greater than Book Value: This is more common and suggests that investors believe the company has strong future prospects, with earnings power exceeding the value of its assets.

• Book Value equals Market Value: When these values are nearly equal, it indicates that the market sees no reason to value the company differently from its assets.

Key Takeaway: Equity Value represents the equity ownership value of a given company, reflecting the value of that company that is attributable to shareholders.

Limitations of Book Value

The book value can be limited by historical cost accounting and depreciation, which might not reflect the current economic value, whereas market value represents the actual price investors and willing to pay for a share in the company. However, it is important to note that market value can be volatile and influenced by market perceptions, economic conditions, and investor sentiment.

Basic Shares vs. Diluted Shares

When discussing equity value, it's important to distinguish between basic shares and diluted shares.

• ‍Basic shares: Is the number of shares currently outstanding.

• ‍Diluted shares: Includes all potential shares that could be created through the conversion of convertible securities or the exercise of options and warrants.

The concept of diluted shares is crucial for a more accurate valuation as it represents the maximum potential equity value.

Therefore, Equity Value is calculated as:‍

Formula: Equity Value = Share Price x Fully Diluted Shares Outstanding (FDSO)

This includes all shares currently issued and outstanding, as well as shares that could be claimed through the conversion of convertible preferred stock or the exercise of outstanding options and warrants.

Enterprise Value

Enterprise Value (EV) measures the total value of a company, including both equity and debt holders. It provides a more comprehensive picture of a company's value, particularly useful for comparing companies with different capital structures.

Formula: Enterprise Value = Equity Value + Net Debt (Total Debt - Cash) + Non-Controlling Interest (NCI) + Preferred Equity

Components of Enterprise Value:

• Equity Value: Total value of outstanding common and preferred shares.

• ‍Net Debt: Sum of short-term and long-term debt (including debt-like items), minus cash balance and marketable securities held by the company.

• ‍Non-Controlling Interest (NCI): Equity value of subsidiaries with less than 50% ownership.

• Preferred Equity: The value of preferred stock issued by the company.

Key Takeaway: Enterprise Value (EV) represents the total value of a given company, reflecting the value of that company attributable to both shareholders and debt holders, offering a comprehensive valuation metric.

Preferred Equity represents a class of ownership in a company that has a higher claim on assets and earnings than common stock. Preferred shareholders receive dividends before common shareholders and have a higher claim in the event of liquidation.

Characteristics of Preferred Equity:

• Dividend Priority: Preferred shares often come with fixed dividends that must be paid out before any dividends are issued to common shareholders.

• ‍Liquidation Preference: In the event of bankruptcy or liquidation, preferred shareholders have a higher claim on assets than common shareholders.

• Conversion Options: Some preferred shares can be converted into a predetermined number of common shares, providing potential for capital appreciation.

• ‍No Voting Rights: Typically, preferred shares do not come with voting rights, which distinguishes them from common shares.

Including preferred equity in the calculation of Enterprise Value ensures that all forms of financial obligations and ownership interests are accounted for, providing a more comprehensive valuation of the company.

The Bridge

To understand the bridge between Equity Value and Enterprise Value, it's essential to recognize the adjustments made to Equity Value:

1. Add Debt: Includes all short-term, long-term debt and debt-like items, such as Unfunded Pension Liabilities, reflecting the company's total financial obligations.
2. Subtract Cash: Cash is deducted because it can be used to pay off debt, reducing the effective cost to acquire the company.
3. Add Non-Controlling Interest: Reflects the value of minority stakes in subsidiaries, ensuring accurate representation of total enterprise value.
4. Add Preferred Equity: Incorporates the value of preferred stock, which has a higher claim on assets and earnings than common stock.

Intercompany Investments

Companies often invest in the equity of other companies, and the accounting treatment varies with the level of ownership.

Let's dive into each method.

Cost Method

When the acquirer holds less than 20% of the equity in another company, these are treated as passive financial investments. For example, if Company A buys a 10% stake in Company B for $1 million, it would record this investment at the acquisition cost on the balance sheet.

Equity Method

‍For ownership stakes between 20% and 50%, the equity method is used. This method assumes significant influence and the investment is recorded at its initial acquisition price. For instance, if Company A buys a 30% stake in Company B, it would recognize its share of Company B's earnings or losses in its income statement.

Consolidation Method

When ownership exceeds 50%, the consolidation method is applied. This means the parent company consolidates the financial statements of the subsidiary with its own, treating the subsidiary as a part of the parent company. For example, if Company A acquires an 80% stake in Company B, it would consolidate Company B's financials with its own, and a new equity line item titled "Non-Controlling Interests (NCI)" would be created on the balance sheet to reflect the 20% not owned by Company A.

Key Takeaway: The consolidation method requires full consolidation if the parent owns more than 50%, creating a "Non-Controlling Interests (NCI)" line on the balance sheet to reflect partial ownership. Net income is separated between the parent and non-controlling interests on the income statement. When calculating Enterprise Value, the non-controlling interest amount is added back, ensuring consistency with certain valuation metrics, such as EV/EBITDA.

Conclusion

The distinction between Equity Value and Enterprise Value is the fundamental topic that you will need to dominate to succeed in interviews. It serves as the basis to performing accurate company valuations.