Valuation methods based on enterprise value have become the benchmark in equity valuation. Most of you will have analysed equity investments using valuation multiples based on a market enterprise value or have applied absolute valuation methods to derive a target enterprise value.
In simplistic terms enterprise value is market capitalisation plus net debt; but is that good enough? In many situations we think not. We review the key building blocks of enterprise value to assist you in deriving relevant valuation metrics.
Enterprise value is a key metric, both in so-called absolute valuation (discounted cash flow, residual income model) and in relative valuation (multiples) that are used to derive the value of equity.1We think that enterprise value provides a better basis for both absolute and relative valuation. For an explanation of why you should use EV based multiples in preference to, for example, a price earnings ratio, see our article ‘Enterprise value: Our preference for valuation multiples’. We define enterprise value as the value of a company’s business activities to all providers of capital to the company.
Enterprise value represents the value of the wealth creating activities of a business. It also equals the value of the various claims on that business. By claims we mean the interest of debt holders, shareholders and others who benefit from that business enterprise through a return on their investment. Most investors are familiar with the accounting equation where assets equal liabilities plus equity. Similarly, enterprise value is the market value of the company’s business, which equals the sum of the value of the various financing claims such as debt and equity.
Total enterprise value versus operating enterprise value
It is important to distinguish between total and operating enterprise value. Total enterprise value is the sum of the value of a company’s operating business plus any other value creating activities such as a separate investment portfolio, investment properties and associates not treated as part of operations. To derive total EV, you need to include all financing claims.
Total enterprise value should be the value of the activities included in the scope of the group consolidated financial statements. For example, if a subsidiary is consolidated then enterprise value would include 100% of the value of that component of the business even if the group investment is only 60%. The other 40% non-controlling interest is also a claim on that enterprise. One of the common mistakes we identify below is omitting full consideration of this non-controlling interest.
Many companies separately identify an operating profit sub-total in their financial statements. Operating enterprise value is the value related to activities that contribute to that operating profit. Operating EV is total EV less the value of any business activities that do not contribute to operating profit.
Separately identifying an operating enterprise value is important because this metric is most useful for deriving valuation multiples and DCF analysis. For example, while investors often refer to EV/EBIT multiples, this is not meant literally; the calculation is more commonly done as operating EV / operating profit.
Operating versus financing liabilities
Any liability could be regarded as a claim on the business enterprise, considering that liability repayments must always come from business cash flows. However, in valuation terms, it is important to differentiate between operating liabilities and financing liabilities, with only the latter being a claim that is included in calculating an enterprise value.
We think the key in deriving an appropriate enterprise value is to categorise line items in the financial statements as either operating or financing. Broadly speaking, operating activities focus on the revenue generating process, while financing activities typically involve transactions with lenders and shareholders. This categorization applies to all items. For the majority of assets, liabilities, income and expenses it is relatively straightforward. However, there are also items where the distinction is less obvious and judgment is required.
One of the problems for investors in categorising items as operating or financing is that the accounting does not fully follow this logic. Operating liabilities and financing liabilities are not clearly differentiated in the balance sheet. Also, it is often not easy to tell which amount in profit and loss relates to which balance sheet item.
For the purpose of operating EV it is also necessary to differentiate between operating and non-operating (or investing) activities. This requires judgment. For example, an investment in associates could either be treated as part of the company’s operations or viewed as a financial investment.
The best approach when deciding what is financing, rather than operating, is to consider whether the liability, including its amount, arises from the normal course of business. Pensions and supply chain finance seem to present particular challenges for investors in practice.
While pension obligations can be said to arise from operations (the liability arises in conjunction with an employment expense), the magnitude of that liability is the result of a financing decision. Companies may choose (or are required by regulation) to fully fund the liability through a dedicated pension fund. In this case there is no net liability on the balance sheet. However, if the obligation is not fully funded, a liability would be reported, and a related finance expense appears in profit and loss.
The principle of enterprise value is to remove the effects of different financing policies from valuation metrics, thereby improving comparability and relevance in equity analysis. Only by including pension liabilities in EV can this be achieved.
Supply chain finance
Normal trade payables arise from operating activities and do not require any adjustment (they are part of net working capital and not included as a liability claim in EV). However, what is labelled as trade payables in financial statements can also arise from financing decisions. Purchasing from suppliers on extended credit terms, and particularly arranging for extended credit through the use of supply chain finance, increases trade payables to beyond what would be expected from a normal working capital cycle. These liabilities should be included in EV if material.2For more about supply chain financing, and how this impacts the balance sheet and cash flow metrics, see our article ‘Leverage and cash flow effects of supply chain finance.
There is no perfect answer to the question of what is ‘financing’ and should be included in an operating EV. Sometimes, such as with trade payables, it may be difficult to differentiate normal operating liabilities from those which arise from financing decisions. However, it is important to consider where the leverage effects of financing decisions arise and, as far as possible, to reflect this in enterprise value.
Common mistakes in enterprise value calculations
The main purpose of this article is to highlight where EV calculations can go wrong. We illustrate some of the challenges in applying enterprise value by referring to its use in valuation multiples, although the issues also apply when using discounted cash flow or other absolute valuation methods.
In obtaining the value of the enterprise for use in EV multiples, we encounter the following common mistakes:
1. Not including all equity-related claims
Enterprise value should include the value of all equity related claims. Market capitalisation of common stock is easy, but many companies issue other equity instruments, the fair value of which also needs to be identified and included in EV. This includes other share classes such as certain preference shares, share warrants, other derivatives classified as equity and employee stock options. Also, as discussed earlier do not forget non-controlling interests, including put options held by minority shareholders.
For many companies, equity claims other than common shares are either zero or not material. However, this is not always the case. It is important that you check and make efforts to include the fair value of all equity claims in EV calculations.
2. Not including all finance-related liabilities
In reviewing which liabilities to include with interest bearing debt, the challenge involves items such as defined benefit pensions and environmental liabilities because these could conceivably be classified either as operating or financing. Our view is that all interest-bearing liabilities should be included in enterprise value.
We would, for example, include the following:
- Provisions for environmental and other non-financial liabilities.
- Defined benefit pension obligations. If this pension obligation is funded, then include the pension scheme deficit or surplus.
- Obligations arising as a result of operating activities, but that are, in substance, financing activities, for example, long-term credit obtained from suppliers or obligations arising from factoring or reverse factoring arrangements.
Prior to 2019, operating leases commitments were off balance sheet, even though they are, in effect, debt financing. This meant that the present value of the operating lease payments should ideally be separately estimated and included as a financing liability to derive an enterprise value. Fortunately, the introduction of more comprehensive lease capitalisation under IFRS 16 means that such adjustments are no longer necessary.
3. Using book value instead of market value
Enterprise value is both the value of a business and the sum of the values of all claims on that business. Therefore, all financing claims must be valued at market (or fair) value instead of using book values from the financial statements. This applies to both debt and equity type claims.
For shareholders’ equity obtaining market value is straightforward because this is simply the market capitalisation. For other types of equity instruments, such as employee stock options and other instruments that are unquoted, it can be more challenging. For non-controlling interests book value can be very different from fair market values; one of the most common mistakes is to use the balance sheet amount for NCI.
For financial liabilities there should not be too much of a problem because the fair value of financial liabilities, including related derivatives, is always disclosed, even if the balance sheet amount is not at fair value. The challenge is that it is not always easy to establish which derivatives are related to the company’s financing.
For non-financial liabilities that are included in EV, such as environmental provisions or pensions, the balance sheet figure is already at a current value, even if not exactly at fair value. Use this balance sheet amount, but remember that for pensions there may be the need to also adjust for taxation. As we have argued previously, we believe the accounting liability is a more appropriate number than the so-called pension funding valuation.3For a discussion about alternative measurement bases for pension liabilities and why we do not think it is appropriate to use ‘funding’ or ‘actuarial’ valuation in equity analysis, see our article ‘Pension liabilities: Not so prudent actuarial values’.
4. Inconsistencies between metrics
In applying enterprise value, it is important that there is consistency between the results metric (profit, cash flow, etc) and the financing components. If a financing claim is included in enterprise value, then the cost of that financing claim should be excluded from the results used in both absolute and relative valuation.
This logic applies to defined benefit pensions. If an estimate of enterprise value includes the value of a pension deficit, then EBIT should not include a deduction for the net interest cost of pensions. Although this presentation of net interest cost of pensions sounds straightforward, you should check the notes to the financial statements. Some companies include the interest components of pensions in operating income.
The same principle applies to extended trade credit and supply chain finance. If you conclude that these liabilities are financing rather than operating in nature, make sure that the related interest expense is not deducted in operating profit.
Consistency between metrics is probably more important than getting the operating / financing split absolutely right. For example, if you cannot identify the interest cost related to financing related trade payables, do not include those payables in EV, thereby avoiding this inconsistency, even if you consider the liability to be financing.
5. Not allowing for seasonal net debt fluctuations
Enterprise value can be a point estimate, such as a current EV, or may be an average for a period, such as when calculating historical multiples to establish trading ranges.4The different pricing bases that are available for valuation multiples, and how the resulting multiples can be used, is described in our article ‘Why you should forward price valuation multiples’. Both of these may be distorted if the metrics used for debt finance and cash balances are affected by seasonal fluctuations. A fluctuation in net debt is, in effect, operating in nature if it arises from a seasonal fluctuation in working capital, perhaps due to different levels of inventory or different receivables due to a seasonal sales profile. In this case it is best to use a seasonally adjusted (mid-cycle) net debt amount.
One of the advantages of earnings and equity multiples is that the interest expense automatically takes any debt seasonality into account. For enterprise value based analysis there needs to be separate consideration given to this issue.
Read the footnotes
Remember that calculating enterprise value requires the use of footnote information as well as the primary financial statements. For example:
- Use the fair value disclosures for financial liabilities to identify the value of finance related claims that are reported at amortised cost in the balance sheet, or to check that the book value is not materially different from fair value.
- For non-financial liabilities included in EV such as pensions, the balance sheet amount is already a current value, but you will need to use the footnotes to identify exactly what liabilities to include and to ensure that related profit metrics are consistently defined.
A call for more fair value disclosures
IFRS and US GAAP financial statements provide much of the information needed to calculate enterprise value, including extensive disclosures of fair values where the balance sheet amounts are measured on an amortised cost basis. However, this is not always the case.
- Fair value or current value information is available for most liabilities. However, fair value is not provided for lease obligations capitalised under IFRS 16. In most cases the difference between book value and fair value will not be material, but that will not always be the case. Making adjustments based on other disclosures is not easy.
- For equity instruments there is no fair value information disclosed at all – in our view this is a weakness in financial reporting because fair value and book value of equity instruments can be very different. If instruments are quoted then there is no problem, but many equity claims are not, particularly derivatives that are classified as equity, including employee stock options.
We would like to see more comprehensive fair value disclosures provided for investors, particularly for equity instruments.5In our article ‘Enterprise to equity bridge – more fair values required’ we examine in more detail the fair value information that is available in financial statements, and the extent to which this is sufficient to derive reliable measures of enterprise value.
Insights for investors
- Sometimes a simplistic calculation of enterprise value as market capitalisation plus net debt taken from the balance sheet works fine; however, this is not always the case.
- Analyse whether liabilities are operating or financing in nature. Trade payables arising from extended trade credit or supply chain financing may be better regarded as financing to ensure comparability.
- If material, make sure you include other claims in enterprise value such as non-controlling interests and equity derivatives.
- Think about what should be excluded from the operating enterprise value that is used for valuation multiples. Our preference is to exclude investments, including associates, financial investments and investment properties, from an operating EV.
- Make sure the market values of claims and investments are reflected in an EV calculation if these differ materially from book values.
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