What is enterprise value and what is equity value? How do you get from Enterprise value to equity value?
Equity value is the valuing of the shares. The value of a share is then the total equity value divided by the number of shares.
An equity value can be calculated using relevant, comparable listed company P/E (Price to Equity) ratios. The appropriate P/E multiple is multiplied against the profit after tax (PAT) to derive the equity value. This gives the total value of all the shares on a minority basis. A controlling equity value would be based on observed controlling takeover transactions, using again the observed P/E.
The problem with calculating equity value in this way is that the amount of debt in the comparable companies or transactions will influence the earnings and so value. The finance structure, the amount of debt, can affect value.
To avoid this influence, the preferable way is instead to first value the business, otherwise known as the Enterprise Value. Enterprise Value ignores the capital structure. It requires looking at comparable companies and transactions on the same basis.
The value of the equity of a listed company is the market share price multiplied by the number of shares. To get to the value of the business, the enterprise value, net debt needs to be added on to the equity value. Net debt is defined as debt less cash.
The driver of enterprise value is un-geared earnings. That is earnings before any interest or tax. What is known as EBIT – Earnings Before Interest & Tax.
Instead of using P/E multiples, Enterprise Value/EBIT comparable company and transaction multiples are used. That multiple is then multiplied against the EBIT of the company.
Once the enterprise value has been calculated then the equity value can be derived. Equity value is calculated by deducting debt, and adding cash, to the enterprise value.
In addition, any surplus assets needed to be added. Surplus assets are assets that are deemed not necessary in generating the earnings in the business. Surplus assets might include:
- Property. Property held in the business would usually be valued separately to the business. As a consequence the earnings of the business would include a deduction for the fair market rent of the property
- Personal assets. In privately held businesses there are sometime assets that are not necessary in the running of the business, for example personal vehicle
- Surplus working capital. For example, the business imports a container load of stock just one a year. The stock has just arrived. As a consequence the level of stock would be much higher than the usual average balance in the business
- Loans to directors
There may also be additional liabilities that need to be deducted, such as:
- Related party loans
- Understated provisions, eg. understated long service leave
- Understated tax liabilities
Consideration also needs to be given to any relevant items that are not on the balance sheet, for example:
- Contingent liabilities, eg. pending litigation
- Franking credits and tax losses
- Unrecorded finance leases
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Simon specialises in providing forensic accounting and valuation services. Prior to founding Lotus Amity, he was a Forensic Accounting partner with BDO Australia and led their National Forensics practice. He has worked as a forensic director for a major offshore forensic accounting practice which included assisting in multi-billion-dollar litigation in relation to the largest Bernie Madoff feeder fund. He has also held senior management positions with Deloitte and Crowe Horwath. Simon is a Chartered Accountant and a Certified Fraud Examiner.
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