Enterprise Value: Why You Add and Subtract Items (23:39)
In this Enterprise Value lesson we take a look at the rules of thumb to figure out what should be added or subtracted when you calculate it.
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The Three Rules of Thumb:
1. Is this item a *long-term funding source* for the company?
In other words, will the funds we raise from this item help fund our business for years to come?
If so, you should ADD this item when calculating Enterprise Value!
Examples: Debt, Preferred Stock, Noncontrolling Interests (Minority Interests), Capital Leases, Unfunded Pension Obligations, Restructuring/Environmental Liabilities…
2. Will this item cost an acquirer of the company something extra when they go to buy it?
And is it NOT something that will be repaid out of the company’s normal operating cash flows (e.g., Accounts Payable)?
If so, ADD it when calculating Enterprise Value!
Examples: Debt, Preferred Stock.
3. Is this item NOT an operating asset?
In other words, could the company continue to operate even WITHOUT this particular asset and be fine?
If so, SUBTRACT it when calculating Enterprise Value!
(These items often “save acquirers money” when buying the company.)
Examples: Cash, Liquid Investments, Net Operating Losses, Assets from Discontinued Operations or Assets Held for Sale…
How Does Each Item In Our Analysis Satisfy This Criteria?
ITEMS THAT YOU SUBTRACT:
Cash – Non-operating asset, the company doesn’t “need” it to run its business beyond a certain low, minimum level.
Liquid Investments – Also non-operating, the company has no need to invest in the stock market if it sells normal products/services.
Equity Investments – Non-operating, not recorded in this company’s revenue/expenses, doesn’t “need” it to run the business.
Other Non-Core Assets – Typically items that will be sold off or discontinued soon, so they’re the very definition of “non-operating.”
NOLs – Also non-operating since long-term tax savings from these are not required to run the business.
ITEMS THAT YOU ADD:
Debt – Long-term funding source, and an acquirer has to repay it.
Preferred Stock – Long-term funding source, and an acquirer has to repay it.
Noncontrolling Interests – Long-term funding source, but this one’s mostly for *comparability*… the company has recorded 100% of revenue and expenses from this company, so we want to capture 100% of its value as well (see our dedicated lesson on this one).
Unfunded Pension Obligations – They’re a long-term funding source!
“Work for us now, we’ll pay you a bit less, but we’ll take care of you when you retire! Really!”
To the company, very much like super-long-term debt…. but owed to employees, not outside investors.
Plus, an acquirer has to pay for these somehow…
Capital Leases – Also a long-term funding source, sort of like debt used to fund PP&E… these leases are used to fund operations and must be repaid.
Restructuring & Legal Liabilities – Increases the cost to an acquirer, and they are also “long-term funding” of a sort – “Instead of paying for these expenses right now, we’ll take care of them far into the future and reflect that liability.”
The Enterprise Value calculation is always somewhat subjective, and you’ll see it done different ways.
Everyone agrees on certain items (Cash, Debt, Preferred Stock), but the treatment of others varies by group, firm, industry, etc.
As long as you can justify and explain how you calculated it, you’ll be fine – even if someone else wants to change it later.
To do that, keep in mind the 3 key rules of thumb above.