In order to compare valuations between different businesses and maintain consistency in a valuation we remove the effects of finance and structure and define a common structure – the enterprise - that applies to all businesses.
The enterprise is the minimum collection of assets and liabilities that are required to operate the business – regardless of how it is financed.
It is a term that is rarely covered in accounting courses or texts and has very little use outside valuation circles, however it is a central concept to the value of the business.
Think of the market value of a house as enterprise value – and equity value is the value left over once the debt to the bank is paid out. It is a similar concept with businesses.
The Enterprise is typically:
Working capital – accounts receivable, accounts payable, WIP, credit accounts, inventory, prepaid expenses, employee provisions and other current assets and liabilities.
Non-current assets required to operate the business – including intangible assets such as goodwill and intellectual property.
As the enterprise is independent of the method of financing, it does not include items such as:
Cash balances.
Non-operating assets such as investments (unless the returns from those assets form part of the expected profits).
Interest-bearing debt.
Non-arms length or related party assets or liabilities that are not core to the operation of the business, such as loans to or from directors.
Income tax provisions.
Deferred tax liabilities.
Future income tax benefits.
The enterprise does not include surplus assets not employed in the operating business, such as investment properties, shareholdings s in other entities or loans to related parties.
In essence:
Enterprise value represents the non-cash operating assets and operating liabilities but excludes long term debt and cash.
Equity value represents the market value of net assets of the business including the cash.
There are different circumstances when each is required:
The sale of the business to a new owner.
Often a new owner will take on only the assets of the business, with the vendor settling all debts as at settlement date.
In other cases the owner will purchase all assets and the current liabilities directly associated with the operation of the business.
This happens as there can be hidden risks associated with the unreported liabilities of an entity such as a company. Buying the assets and liabilities of the enterprise means there is no contingent risk from unknown legal or financial liabilities.
This is enterprise value
The sale of a portion of the business refers to the equity value.
A new owner(s) is coming into the entity and will take on the share of assets and liability for its debts (depending on the structure adopted). For this reason the equity value is required.
This will happen when taking on a new investor, selling a portion of the business to employees or when buying out a partner.
Reporting to the ATO will typically require equity value in order to arrive at the capital gain in the equity.
When an income method (such as DCF or earnings multiple) is used to determine the value, we are usually calculating enterprise value. We use EBIT (or EBITDA) as a proxy for firm-level cash flow and therefore we must also use a cost of capital of the enterprise (or an EBIT or EBITDA multiple) to determine the enterprise value.
Equity value then becomes enterprise value less net debt, where net debt is long term commercial debt less cash.
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