Enterprise Valur Equation

Why does EV equation add total debt to the market Cap of a company? Shouldn't outstanding debt make the company less valuable??

Answers

  • I would say that debt actually adds value to a company because it represents assets the company can use to produce more income.

    Debt is often called leverage because it increases the earnings power of a business. Usually you are only liable for a small portion of the debt over a given period however you have the full value of the loan to produce more income.

    There is a way in management accounting to set up a comparative income statement or cost analysis that would look at projected earnings under different models. As you increase debt you can increase relative earnings per share or return on equity.

    At a certain point dependent on the industry and cost configuration you would start to see diminished return if you increase leverage further. This is usually the point management wants to stay at or a little below to maximize profits for shareholders.

    The only problem is if the terms of the liabilities change or earnings power goes down than you would have to adjust your budget and earnings forecast accordingly. Here you would want to have a margin of safety to accommodate for those fluctuating market variables.

    Hence highly leveraged companies earn more but are riskier business to own.
  • Thank so much for your response. There are lots a valid points.

    Below is what I got from Investopedia:

    <b class="Bold">EV = market value of common stock + market value of preferred equity + market value of debt + minority interest - cash and investments.

    BREAKING DOWN 'Enterprise Value (EV)'

    Enterprise value can be thought of as the theoretical takeover price if the company were to bought. In the event of such a buyout, an acquirer would generally have to take on the company's debt, but would pocket its cash for itself. EV differs significantly from simple market capitalization in several ways, and many consider it to be a more accurate representation of a firm's value.

    The value of a firm's debt, for example, would need to be paid by the buyer when taking over a company, thus enterprise value provides a much more accurate takeover valuation because it includes debt in its value calculation.</b>

    The way I am thinking of it is: if I what to buy a company, I have to take into account any debt that it currently has. I will be responsible for paying that debt if I indeed buy the company. So my $ offer to buy the company (i.e. its enterprise value) would be less than if the company had no debt (for which I would become responsible for paying).

    Am I missing something?

  • Yeah no problem, I just though of a really simple example after.

    If you wanted to buy a house for 100,000 but the owner only had 50,000 in equity in the home and still had a mortgage of 50,000 remaining. The house is still worth 100,000 total which would be the price of the asset.

    The only reason you subtract cash is because even though it is an asset it does not generate value unless it is being used. Hence you would subtract it from the total value to reduce liabilities and get your EV. The only thing with EV is it also based on future earnings power as well hence the other parts of the equation.
  • I like this discussion. As I understand EV it is mainly a parameter to compare how expensive the company is prised compared to similar businesses. My knowledge does not take me further than that.
  • Yes and also to show certain multiples. If we take EV/ Operating Earning or EV/ EBIT it shows us the multiple we pay based off the main core of the business.

    As you said it is usually for relative valuation. However, it gives you an idea of the multiple your paying for earnings.

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