In a prior article we explained the basics of valuation multiples, and how they are used to calculate the fair market value of a business. In this article, we will explain the differences between enterprise value and equity value, and in particular, how these differences impact privately-owned businesses.
Valuing the Operations of Profitable Companies
When valuing a private company that generates consistent profits, the most common methods of valuation are as follows:
- Capitalized Cash Flows (“CCF”): This approach involves an analysis of past results (i.e. financial statements), and considers adjustments to “normalize” annual cash flows. A valuation multiple is applied to the normalized cash flows, in order to convert that stream of income into an estimate of value.
Consider the example of Company A that generates annual EBITDA of $600,000, and an EBITDA multiple of 3x. Company A is worth approximately $1.8 million.
- Discounted Cash Flows (“DCF”): This approach involves a projection of future results, typically prepared by management. A discount rate is applied to these expected cash flows, in order to convert their future value to the present.
Consider that Company A is also worth $1.8 million today, based on its forecasted EBITDA.
The Impact of Net Debt
In either case, the $1.8 million value refers to the total value of the operations of the business. This is the Enterprise Value, or the value of the business to its shareholders and creditors. It can be helpful to think of this like a home. Consider someone who wants to sell their home, and assume that the home is worth $1 million, with a $400,000 mortgage.
In this analogy, the “Enterprise Value” of the home is $1 million. However, if the owner were to sell the home, they would not be left with $1 million. They would have to pay off the mortgage, so they would be left with $600,000. That $600,000 is the owner’s “Equity Value”.
With respect to Company A above, assume that it has a banking facility of approximately $750,000, and cash of $50,000. The net amount of debt is $700,000 ($750,000 less $50,000). If we deduct this “Net Debt” of $700,000 from the Enterprise Value of $1.8 million, we arrive at the Equity Value of $1.1 million.
Here, we see that if the owners of Company A were to sell the business for $1.8 million, they would only be entitled to $1.1 million of the proceeds, before applicable taxes, of course.
Considering Redundant Assets and Liabilities
We noted above that Enterprise Value refers to the total value of the operations of the business. This means that this includes the assets that the business uses to operate. So, what if the business has assets or liabilities that are not necessarily used for operations, such as an investment portfolio or an amount owing to a shareholder?
In valuations, these are referred to as “Redundant Assets or Liabilities”. That is, they are not required for operations, so their value is separate from that of a company’s operations. While these items would not be included in Enterprise Value, they would be included in the determination of Equity Value. After all, these are still assets or liabilities of the company.
Consider if Company A’s Enterprise Value is the same as above ($1.8 million), but that the company also has an investment portfolio of $400,000, and an amount owing to a shareholder of $100,000. The Equity Value would be calculated as follows:
|Enterprise Value||$ 1,800,000|
|Amount owing to Shareholder||(100,000)|
|Equity Value||$ 1,400,000|
What does this mean for your business?
The distinction between Enterprise Value and Equity Value is important, since the latter may be required for a number of considerations, including:
- The value required to execute an estate plan or a reorganization.
- The pre-tax proceeds from the sale of the business that would flow to the shareholders.
- To obtain financing from a lender.
Do not hesitate to reach out to your professional advisors if any of these items appear to be relevant to your business. If you are considering buying or selling a business, or implementing succession and tax planning, our team at Grewal Guyatt LLP would be happy to provide a free consultation to discuss these and similar matters to ensure that you maximize your value according to your objectives.
Tom Strezos, CPA, CA, CBV, CFE, ASA
Valuations and Litigation Support
Direct: (905) 747-5162
Claudio Martellacci, CPA, CA, CBV
Direct: (289) 819-1744