Enterprise value (EV), also called firm value or total enterprise value (TEV), tells us how much a business is worth. You can calculate enterprise value using a number of valuation techniques like discounted cash flow (DCF) analysis, but for now we'll simply calculate EV as follows:
EV = Equity Value + Net Debt + Noncontrolling Interest + Preferred Stock + Capital Leases
Enterprise value is the theoretical price an acquirer might pay for another firm, and is useful in comparing firms with different capital structures since the value of a firm is unaffected by its choice of capital structure.
A public company's equity value, or market capitalization, is shareholders' residual interest after paying off all senior claims such as debt and preferred stock. It is calculated as the current share price multiplied by the number of diluted shares outstanding. To calculate diluted shares, you need to first find the number of basic shares on the front of the latest company SEC filing (e.g. 10-K, 10-Q, 20-F). Add to that number any restricted shares and net shares resulting from the exercise or conversion of options, warrants, and convertible securities to get diluted shares outstanding.
The net share equivalents resulting from the exercise of options is calculated using the treasury method:
- Assumes that proceeds from the exercise of options are used to repurchase shares at the current market price
- Net share equivalents = options − (options × exercise price ÷ current market price)
- Includes all outstanding in-the-money (ITM) options, whether vested or not
Convertible securities, which can be debt or preferred stock, are convertible into common shares at a specific stock price known as the conversion price or strike price or exercise price. Only in-the-money (ITM) convertible securities impact diluted share count.
- If the current stock price is greater than the conversion price, the convertibles are ITM
- ITM convertible securities increase the number of shares outstanding by the amount of new shares issued upon conversion
- New shares issued = face value of ITM convertibles ÷ conversion price
- Upon conversion, the face value of ITM convertibles is subtracted from debt or preferred stock, as appropriate, and added to common equity
When a convertible security has a fixed coupon interest payment, determining whether or not the security is ITM can be complicated. In these cases, add the present value of all future interest payments (per share) to the conversion price and compare the sum to the current stock price.
Net debt is equal to total debt less cash and cash equivalents. When calculating total debt, be sure to include both the long-term debt and the current portion of long-term debt, or short-term debt. Any in-the-money (ITM) convertible debt is treated as if converted to equity and is not considered debt.
When calculating cash and equivalents, you should include such balance sheet items as Available for Sale Securities and Marketable Securities, even if they are not classified as current assets on the balance sheet. Do not include restricted cash in this calculation. Restricted cash is not often explicitly identified on the balance sheet, but can be estimated as a percent of cash and equivalents depending on the industry, for example. In practice, however, we generally ignore restricted cash unless it is explicitly identified on the balance sheet or elsewhere in company filings.
The market value of debt should be used in the calculation of enterprise value. However, in practice we can usually use the book value of the debt by assuming that the debt trades at par. This assumption would be inappropriate in the valuation of distressed companies, whose debt will trade significantly below par.
In practice, noncontrolling interest, preferred equity not convertible into common stock, and capital leases are sometimes bundled into the net debt calculation. We will assume net debt includes these components when we refer to it in our coverage of valuation topics.
Noncontrolling (Minority) Interest
Noncontrolling interest, formerly known as minority interest, represents the interest of noncontrolling shareholders in the net assets of a company and is reported in the shareholders' equity section of the balance sheet (or in the "mezzanize section" between liabilities and equity prior to FAS 141r). For example, a parent company might have an 80% controlling interest in a consolidated subsidiary, while the remaining 20% noncontrolling interest is owned by another company. If noncontrolling interest is excluded from the calculation of enterprise value, the consolidated EBITDA, EBIT, etc. should be similarly adjusted to exclude the portion not attributable to the parent company.
Preferred equity that is not convertible into common stock is treated as a financial liability equal to its liquidation value and included in net debt. Liquidation value is the amount the firm must pay to eliminate the obligation.
Example 5.1 – Calculating Enterprise Value
Tango's balance sheet and options table on 3/31/09 are shown below. Shareholders' equity includes $70 of noncontrolling interest. The current stock price is $22.00 and Tango has 62.754 million basic shares outstanding. What is Tango's enterprise value?
Example 5.2 – Calculating Enterprise Value
Tango's balance sheet on 3/31/09 is shown below. Assume the options table from Example 5.1. The zero-coupon convertible debt has a conversion price of $25.50. The current stock price is $22.00 and Tango has 62.754 million basic shares outstanding. Tango has no noncontrolling interest. What is Tango's enterprise value at its current stock price and theoretical acquisition prices of $24.00, $26.00, and $28.00?
Note that equity value and net debt will change depending on whether or not the convertible debt is in-the-money.