What is Enterprise Value vs. Equity Value?
Enterprise Value vs. Equity Value is an often-misunderstood topic, even by newly hired investment bankers. Understanding the distinction ensures that the free cash flows (FCF) and discount rates are consistent and that valuation models are built correctly.
Enterprise Value Definition
Questions surrounding enterprise value vs equity value seem to pop up frequently in our corporate training seminars. In general, investment bankers seem to know a lot less about valuation concepts than you’d expect given how much time they spend building models and pitchbooks that rely on these concepts.
There is, of course, a good reason for this: Many newly hired analysts lack training in “real world” finance and accounting.
New hires are put through an intense “drinking through firehose” training program, and then they’re thrown into the action.
Previously, I wrote about misunderstandings surrounding valuation multiples. In this article, I’d like to tackle another seemingly simple calculation that is often misunderstood: Enterprise value.
Learn More → Enterprise Value Quick Primer
Enterprise Value Interview Question
Enterprise Value (EV) Formula
I have often been asked the following question (in various permutations):
Enterprise Value (EV) = Equity Value (QV) + Net Debt (ND)
If that’s the case, doesn’t adding debt and subtracting cash increase a company’s enterprise value?
How does that make any sense?
The short answer is that it doesn’t make sense, because the premise is wrong.
In fact, adding debt will NOT raise enterprise value.
Why? Enterprise value equals equity value plus net debt, where net debt is defined as debt and equivalents minus cash.
Enterprise Value Home Purchase Value Scenario
An easy way to think about the difference between enterprise value and equity value is by considering the value of a house:
Imagine you decide to buy a house for $500,000.
- To finance the purchase, you make a down payment of $100,000 and borrow the remaining $400,000 from a lender.
- The value of the entire house – $500,000 – represents the enterprise value, while the value of your equity in the house – $100,000 – represents the equity value.
- Another way to think about it is to recognize that the enterprise value represents the value for all contributors of capital – for both you (equity holder) and the lender (debt holder).
- On the other hand, the equity value represents only the value to the contributors of equity into the business.
- Plugging these data points into our enterprise value formula, we get:
EV ($500,000) = QV ($100,000) + ND ($400,000)
So back to our new analyst’s question. “Does adding debt and subtracting cash increase a company’s value?”
Imagine we borrowed an additional $100,000 from a lender. We now have an additional $100,000 in cash and $100,000 in debt.
Does that change the value of our house (our enterprise value)? Clearly not – the additional borrowing put additional cash in our bank account, but had no impact on the value of our house.
Suppose I borrow an additional $100,000.
EV ($500,000) = QV ($100,000) + ND ($400,000 + $100,000 – $100,000)
At this point, a particularly clever analyst may answer, “that’s great, but what if you used that extra cash to make improvements in the house, like buying a subzero fridge and adding a jacuzzi? Doesn’t net debt go up?” The answer is that in this case, net debt does increase. But the more interesting question is how the additional $100,000 in improvements affects enterprise value and equity value.
