Corporate Finance

AF4801

12/06/2022 Syed Muhammad Ali Raza

 Enterprise Value
Enterprise Value (EV):

Enterprise value (EV) measures a company's total value, often used as a more comprehensive
alternative to equity market capitalization. EV includes in its calculation the market capitalization
of a company but also short-term and long-term debt and any cash or cash equivalents on the
company's balance sheet.

• Enterprise value (EV) measures a company's total value, often used as a more comprehensive
alternative to equity market capitalization.
• Enterprise value includes in its calculation the market capitalization of a company but also
short-term and long-term debt and any cash on the company's balance sheet.
• Enterprise value is used as the basis for many financial ratios that measure a company's
performance.

12/06/2022 Syed Muhammad Ali Raza

 Enterprise Value
Components of Enterprise Value (EV):

Enterprise value uses figures from a company's financial statements and current market prices. The components that
make up EV are:

Market cap: The total value of a company's outstanding common and preferred shares
Debt: The sum of long-term and short-term debt
Unfunded pension liabilities (if any): The amount of capital lacking to cover pension payouts or the amount a
company needs to set aside to make pension payments in an unfunded plan. Can be added market cap if this value is
present.
Minority interest: The equity value of a subsidiary with less than 50% ownership. It can be added to market cap for
EV calculation.
Cash and cash equivalents: The total amount of cash, certificates of deposit, drafts, money orders, commercial
paper, marketable securities, money market funds, short-term government bonds, or Treasury bills a company
possesses.

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 Enterprise Value

To calculate market capitalization—if not readily available — you would multiply the number of outstanding
shares by the current stock price. Next, total all debt on the company's balance sheet, including both short-
term and long-term debt. Finally, add the market capitalization to the total debt and subtract any cash and
cash equivalents from the result.

12/06/2022 Syed Muhammad Ali Raza

 Enterprise Value
Enterprise value (EV) differs significantly from simple market capitalization in several ways, and many consider it to
be a more accurate representation of a firm's value. EV tells investors or interested parties a company's value and
how much another company would need if it wanted to purchase that company.

There is one other consideration: a company's EV can be negative if the total value of its cash and cash equivalents
surpasses that of the combined total of its market cap and debts. This is a sign that a company is not using its assets
very well—it has too much cash sitting around not being used. Extra cash can be used for many things, such as
distributions, buybacks, expansion, research and development, maintenance, employee pay raises, bonuses, or
paying off debts.

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 Enterprise Value
EV as a Valuation Multiple

Enterprise value is used as the basis for many financial ratios that measure the performance of a company. For
example, the enterprise multiple contains enterprise value. It relates the total value of a company from all sources to a
measure of operating earnings generated—the earnings before interest, taxes, depreciation, and amortization
(EBITDA).

EBITDA measures a company's ability to generate revenue and is used as an alternative to simple earnings or net
income (in some circumstances). EBITDA, however, can be misleading because it strips out the cost of capital
investments like property, plant, and equipment. Another figure, EBIT, can be used as a similar financial metric without
the drawback of removing depreciation and amortization expenses related to property, plant, and equipment (PP&E).
EBITDA Calculation

EBITDA is calculated using the following formula:

EBITDA = Net Income + Interest Expense + Taxes + Depreciation + Amortization

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 Enterprise Value
EV/EBITDA:

The enterprise multiple (EV/EBITDA) metric is used as a valuation tool to compare the value of a company and its
debt to the company’s cash earnings, less its non-cash expenses. As a result, it's ideal for analysts and investors
looking to compare companies within the same industry.

EV/EBITDA is useful in several situations:

• The ratio may be more useful than the P/E ratio when comparing firms with different degrees of financial
leverage (DFL).
• EBITDA is helpful in valuing capital-intensive businesses with high levels of depreciation and amortization.
• EBITDA is usually positive even when earnings per share (EPS) is not.

EV/EBITDA has a few drawbacks:

• If working capital is growing, EBITDA will overstate cash flows from operations (CFO). Further, this measure
ignores how different revenue recognition policies can affect a company's CFO.
• Because free cash flow to the firm captures the number of capital expenditures (CapEx), it is more strongly
linked with valuation theory than EBITDA. EBITDA will be a generally adequate measure if capital expenses equal
depreciation expenses.
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 Enterprise Value
EV/Sales:

Another commonly used multiple for determining the relative value of firms is the enterprise value to sales ratio or
EV/sales. EV/Sales is regarded as a more accurate measure than the Price/Sales ratio since it considers the value and
amount of debt a company must repay at some point.

It's believed that the lower the EV/Sales multiple, the more attractive—or undervalued—the company is. The
EV/Sales ratio can be negative when the cash held by a company is more than the market capitalization and debt
value. A negative EV/sales implies that a company can pay off all of its debts.

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 Enterprise Value
Enterprise Value vs. Market Cap

Market capitalization leaves a lot of essential factors out, such as a company's debt and cash reserves.

Enterprise value is a modification of market cap, as it incorporates debt and cash for determining a company's value.

Here's an example: imagine two identical manufacturers, Company A and Company B, have the same stock price of
$4.32 per share. Each have 1 million outstanding shares with a market cap of $4.32 million.

Debt and Cash Change the View

Now, imagine Company A has $500,000 in cash and cash equivalents and $250,000 in total debt. Its EV (total worth)
is $4,320,000 + $250,000 - $500,000 = $4.07 million.

Company B has $1 million in cash and $250,000 in debt. It's EV is $4,320,000 + $250,000 - $1,000,000 = $3.57
million.

The companies looked identical using market cap, but a much different picture appears when EV is calculated.

12/06/2022 Syed Muhammad Ali Raza

 Enterprise Value
Enterprise Value vs. P/E Ratio
The price-to-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its current share price relative
to its earnings per share (EPS).

The price-to-earnings ratio is sometimes known as the price multiple or the earnings multiple. The P/E ratio doesn't
consider the amount of debt that a company has on its balance sheet.

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 Enterprise Value
Limitations of EV:

As stated earlier, EV includes total debt, but it's essential to consider how the company's management utilizes the
debt. For example, capital-intensive industries such as the oil and gas industry typically carry significant amounts of
debt, which is used to foster growth. The debt could have been used to purchase a plant and equipment. As a result,
the EV can be skewed when comparing companies across industries.

This is essential to consider if the company being looked at is undergoing a merger or acquisition. This is because the
acquiring company will need to account for the amount of debt it is taking on in the merger. Investors can use this
information to evaluate what the merged companies will look like in the future.

As with any financial metric, it's best to compare companies within the same industry to better understand how the
company is valued relative to its peers.

12/06/2022 Syed Muhammad Ali Raza

 Enterprise Value
Example:

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 Enterprise Value

Macy’s EV = $ 9.03 billion

Enterprise value is considered comprehensive when valuing a company because, if a company were to purchase
Macy's outstanding shares for $7.44 billion, it would also have to settle Macy's $3.30 billion in outstanding debts.
In total, the acquiring company will spend more than $10 billion to purchase Macy's. However, since Macy's has
$1.71 billion in cash, this amount could be added to repay the debt.

In Perspective of Investor:
Enterprise value estimates a company's total value, generally used by other companies when considering a merger
or acquisition. Investors can also use EV to estimate a company's size and worth to help them evaluate their stock
choices.

EV is best used with other metrics for valuating a stock. Some popular ratios are EV/Sales and EV/EBITDA,

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 Free Cash Flows:
Warm-up: Forget about all the complicated financial statements relationship for a minute and simply picture the
firm as a cash processor. Cash flows into the firm in the form of revenue as it sells its product and cash flow out as it
pays its cash operating expenses e.g; salaries and taxes etc, but not interest expense, which is financing and not an
operating expense. The firm takes the cash that’s left over and makes short-term net investments (e.g inventory &
receivable) and long-term investments in property plant and equipment (PP & E). The cash that remains is available
to pay out the firm’s investors; bondholders & common shareholders (let’s assume for the moment that the firm
has not issued preferred stock). That pile of remaining cash is called free cash flow to the firm (FCFF) because it’s
free to pay out to the firm’s investors, including stockholders & bondholders. After the firm buys and sells products,
provides services, pays its cash operating expenses, and makes short-term and long-term investments.

What does the firm do with its FCFF? First, it takes care of its bondholders because common shareholders are paid
after all creditors. So it makes interest payments to bondholders and borrows more money from them or pay some
of it back. However, making interest payments to bondholders has one advantage to common shareholders: it
reduces the tax bill.

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 Free Cash Flows:
Calculating Free Cashflow from Net Income:

FCFF = NI + NCC + Int(i-t) –FCInv – WCInv

FCFE = NI + NCC – FCInv – WCInv + net borrowing

Calculating Free Cashflow from Statement of Cash Flows(assuming after-tax intrest expense classified as
operating outflow):

FCFF = CFO + Int(i-t) - FCinv

FCFE = CFO – FCInv + Net borrowing

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Example:

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 Free Cash Flows:

12/06/2022 Syed Muhammad Ali Raza

 Free Cash Flows:

12/06/2022 Syed Muhammad Ali Raza

 Free Cash Flows:

12/06/2022 Syed Muhammad Ali Raza