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 enterprise value or used absolute valuation methods to derive an 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 also in relative valuation (multiples) methods to derive the value of equity. 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 entity. 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 activities 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, say, 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 as this metric is most useful for deriving valuation multiples and in DCF analysis. For example, while investors 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 categorize 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 categorizing items as operating or financing is that the accounting does not fully follow this logic. Operating liabilities and financing liabilities are not differentiated well 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 judgement. For example, an investment in associates that could either be treated as part of the company’s operations or viewed as a financial investment.
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, 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 next to interest bearing debt, the challenge involves items such as defined benefit pensions and environmental liabilities as these could conceivably be either be classified as operating or financing. Our view is that all interest-bearing liabilities should be included in enterprise value.
This means that we would, for example, include the following:
Prior to 2019, operating leases commitments were off balance sheet, even though we would regard them as, 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 the value of a business as represented by sum of the values of all claims on a 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 as this is simply the market capitalisation. For other types of equity instruments, such 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 as 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.
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 either absolute or relative valuation. The same logic applies to defined benefit pensions. If an estimate of enterprise value includes the value of a pension deficit, then EBIT should be before deducting the net interest cost of pensions. Although this presentation of net interest cost of pensions sounds straightforward, you might want to check the notes to the financial statements. Some companies include the interest components of pensions in operating income.
Read the footnotes
Remember calculating enterprise value requires the use of footnote information as well as the primary financial statements. For example:
A call for more fair value disclosures
IFRS 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.
We would like to see more comprehensive fair value disclosures provided for investors, particularly for equity instruments.
And finally …
In many cases 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. Think carefully about including all claims in EV, about what is best excluded from the operating EV used for multiples. Make sure that it is the market values of claims and investments that are reflected if these differ materially from book values.