For many business executives, the company they own represents a large proportion of their total personal wealth and will often represent a major element in their future financial planning. As such it is critical to have a clear and comprehensive understanding of the concepts involved in company value measurement.

In this post we'll consider how Enterprise Value is calculated; the concepts behind it and also explain the relationship to Equity Value. For the purposes of this discussion, we will be considering the terminology from a UK perspective, and primarily addressing unquoted companies, i.e., private limited companies, as per the Companies Acts. 

So, what exactly is Enterprise Value? In essence it is the value assigned to the business that is operated within and by the company. It is as well to fully appreciate the nuances that statement as it is a key to fully grasping Enterprise and Equity Values. To elaborate let’s understand the pieces in the jigsaw. The shareholders own the company. That ownership is evidenced by their shares and those shares bestow on them various rights. The company is a separate legal entity (a body corporate) and can act in its own right. The directors are appointed to perform duties on behalf of the company. Although the directors and shareholders in many companies may be the same people, their rights, duties and responsibilities in those two capacities are significantly different. However, that is a topic for a separate discussion. 

The company owns and operates the business for the benefit of the shareholders, and in that capacity, will do so to achieve the objectives of the shareholders. The Enterprise Value is the value assigned to the business activities the company has created. As mentioned, the directors manage and operate that business on behalf of the company. 

It is important to note that any value arrived at relates to a specific point in time as it is directly associated with and dependent upon, circumstances prevailing at that time. All valuations are subjective, as they depend upon the opinion of the valuer, and that opinion is influenced by the information and circumstances prevailing at the time the opinion is formed.

How is Enterprise Value calculated? It is possible to find in some corporate finance texts the equation below, describing how to calculate the Enterprise Value.

EV = EQ + Debt – Cash

Where:

EV is Enterprise Value, and

EQ is Equity Value

This calculation effectively describes the interrelationships of three of the jigsaw elements discussed above. The business is represented by Enterprise Value, the shareholders in essence Equity Value, the company is essentially the funding model expressed as Debt and Cash.

 

This calculation is correct in the circumstances of quoted companies, because the Equity Value is readily available as it is the total of the quoted price per share multiplied by the total number of shares. Working back from that figure and adjusting for balance sheet values can provide the Enterprise Value. However, in the circumstances of a private, or unquoted company the equation is inappropriate as equity value is not readily available and as a consequence Enterprise Value has to be determined to enable value to be assigned to the company shareholdings. For the private company shareholder, the Equity Value is key. 

Another complicating factor for private companies is that shares of the same class may not all have the same value attributed to them. It is a reality in such companies, that an uninfluential minority stake would often attract a value discount compared to the value of a majority stake. 

In the realm of quoted company analysts, the drivers of PE Ratios and share values are paramount. However, as noted by Christopher G Glover in Valuation of Unquoted Companies, and despite the rational supposition that earnings growth is related to PE ratios and share price no correlation could be established for either a sample of stocks or a single share over time. A definite correlation could however be established between price and expected moves in interest rates. 

Rather than diminishing the importance of earnings in a valuation model, the findings identified in the pricing of quoted shares, perhaps have more relevance in considering the less than perfect market associated with those shares, the influence of “market knowledge” and the very nature of buy and sell decisions which are often driven short term influences and considerations. 

In private companies, there is no ready market for the shares and any transaction requires the coming together of a ready, willing and able buyer and seller. Even then there may be impediments to a transaction as a result of the company’s Articles of Association or the terms of a Shareholder Agreement. As such transactions in private companies tend to be far less frequent and are often a major event for the whole company.  

Whilst accepting the validity of the equation, EV = EQ + Debt – Cash, but acknowledging that there is no readily available figure for EQ, the only way to arrive at the value of EV is to value the underlying business. We have already established the relationship between the business and Enterprise Value. Business valuation in the case of private companies is a technical process requiring considerable knowledge and experience but, in every instance, a subjective process. There are many valuation models, each having advantages and limitations. Each model in itself involves subjective judgements on the part of the valuer and there is then an overall assessment as to which model and its associated result is appropriate in the particular circumstances.

Some sources would have it believed that a business value can be arrived at by applying a multiple to the Net Profit/EBIT/EBITDA figure to arrive at a business value. In an absolute mathematical sense, the business value can be expressed as:

BV = P x M

Where:

BV = Business Value

P = “Profit”

M = Multiple

However, the key unknown in this equation is M the multiple. Do not be deceived by anyone who would suggest that the multiple to be applied is a function of size, be that turnover or profit, or that there are standard multiples to be applied to a given business activity or sector. This is simply not the case. The correct multiple for a given business is influenced by a whole multitude of factors both internal and external to the business which are quite specific to that business. As already identified, when the valuation is undertaken is important, as the impact of influences will change over time. 

Having arrived at the business value, which we have seen is also EV, the valuer can make the cash and debt adjustment to arrive at EQ. The reason why this correction is made between EV and EQ, is because the business value is largely independent of the funding model applicable. The funding model is a function of company decisions; whether those are to leave excess cash with the business, meet business requirements out of borrowings, when and how much dividend to pay etc. In arriving at an EQ therefore it is accepted that an adjustment to reflect the impact of such decisions is appropriate. 

That completes the loop of the relationship between EV and EQ and how it operates in the realm of private companies.

Please feel free to like and share. If you found this article has raised any questions, or you have some alternative views please add a comment. However, should you like to discuss and consider how these issues might impact on your business specifically please feel free to contact directly.