ENTERPRISE VALUE

ENTERPRISE VALUE : CONCEPT

 Enterprise value is a measure of the actual economic value of a

company at any given moment
 A measure of a company's value
 Often used as an alternative to straightforward market capitalization.
 EV is a figure that represents the entire cost of a company if
someone were to acquire it.
 It is what it would cost to buy every single share of a company’s
common stock, preferred stock, and outstanding debt.

 EV formula  market cap

+ debt, minority interest and preferred shares,

- total cash and cash equivalents.

 COMPONENTS OF EV
 Market Capitalization: Frequently called “market cap”, market capitalization
is calculated by taking the number of outstanding shares of common stock
multiplied by the current price-per-share.

 Preferred Stock: Although technically equity, preferred stock can actually

act as either equity or debt, depending upon the nature of the individual
issue.
A preferred issue that must be redeemed at a certain date at a certain price is,
for all intents and purposes, debt.
In other cases, preferred stock may have the right to receive a fixed dividend
plus share in a portion of the profits (this type is known as “participating”).
Regardless, the existence represents a claim on the business that must be
factored into enterprise value.

 Debt: “ Once you’ve acquired a business, you’ve also acquired its debt” .If
someone were to acquire that company, they would also acquire
responsibility for that debt.

 Cash and Cash Equivalents: Once you’ve purchased a business, you own
the cash that is sitting in the bank.. In effect, it serves to reduce your
acquisition price; for that reason, it is subtracted from the other components
when calculating enterprise value.
POINTS TO KEEP IN MIND WHILE CALCULATING EV

 All the components are market, not book values.

 Cash is subtracted because when it is paid out as a dividend, it reduces
the net cost to a potential purchaser. Therefore, the business was only
worth the reduced amount to start with. The same effect is accomplished
when the cash is used to pay down debt.
 Value of minority interest is added because it reflects the claim on assets
consolidated into the firm in question.
 Value of associate companies is subtracted because it reflects the claim on
assets consolidated into other firms.
 EV should also include such special components as unfunded pension
liabilities, executive stock options, environmental provisions, abandonment
provisions, and so on, for they also reflect claims on the company's assets.
 EV can be negative in certain cases —for example, when there is too
much cash in the company.
 WHY USE ENTERPRISE VALUE ??

 EV is a more accurate estimate of takeover cost than market

capitalization because it takes includes a number of important factors
such as preferred stock, debt, and cash reserves that are excluded
from the latter metric.
 Debt and cash are economic realities and must be factored into the
purchase price an acquirer pays for a company.
 use this instead of market capitalization because it is the actual
economic purchase price of a company at any given moment EV
reflects the actual purchase price anyone acquiring a company would
have to pay.
 Because EV is a capital structure -neutral metric, it is useful when
comparing companies with diverse capital structures.
 Buyers of controlling interests in a business use EV to compare
returns between businesses  how much to pay for the whole entity
(not just the equity).
 IMPLICATIONS OF EV
 From a buyer's perspective

 the more debt and the less cash a company has, the more expensive
owning it will be, since the debts must be paid off and there's little cash
to offset the interest.

This reduces the price the acquirer is willing to pay.

 EV it penalizes companies with a lot of debt and low cash balances,

while rewarding companies with low debt and lots of cash.

 low-debt, high-cash companies  higher quality as they can more

easily survive an economic downturn or business problems, and have
more flexibility in how to reward shareholders. With lots of cash and little
debt, the company can pursue growth through new business lines or
acquisitions, and can afford to buy back more shares or pay a higher
dividend.

 On the other hand, those with high debt and low cash suffer the loss of
profits through interest payments, and are also at risk of bankruptcy if
business goes south and they can no longer afford to cover interest
obligations.
DISCOUNTED CASH FLOW
MODEL
 INTRODUCTION
 In finance, the discounted cash flow (DCF) approach describes a
method of valuing a project, company, or asset using the concepts of
the time value of money. All future cash flows are estimated and
discounted to give their PV. The discount rate used is generally the
appropriate WACC, that reflects the risk of the cashflows.

 A method for determining the current value of a company using future

cash flows adjusted for time value. The future cash flow set is made up
of the cash flows within the determined forecast period and a continuing
value that represents the cash flow stream after the forecast period.

 Discounted cash flow approach has received greater attention,

emphasis an acceptance from early 1990s mainly because of its
conceptual superiority and its strong endorsement by leading
consultancy organizations.
MEANING
 Valuing a firm using the discounted cash flow approach calls for
forecasting cash flows over an indefinite period of time for an
entity that is expected to grow.

 This is indeed a daunting proposition.

 To tackle this task, in practice, the value of the firm is separated

into two time periods:

Value of the firm = PV of cash flow during an explicit forecast period +

PV of cash flow after the explicit forecast period.

During the explicit forecast period-which is often a period of 5 to 15 years- the

firm is expected to evolve rather rapidly and hence a great deal of effort is
expended to forecast its cash flows on an annual basis. At the end of the
explicit forecast period, the firm is expected to reach a “steady state” and
hence a simplified procedure is used to estimate its continuing value.
STEPS INVOLVED

1. Forecast the cash flow during the explicit

forecast period.
2. Establish the cost of capital.
3. Determine the continuing value at the
end of the explicit forecast period.
4. Calculate the firm value and interpret
results.
STEP 1. CASH FLOW FOR EXPLICIT
PERIOD
For obtaining the cash flow forecast during the
explicit period, the following steps may be
obtained:

A. Select the explicit forecast period.

B. Define the free cash flow to the firm.

C. Develop the free cash flow forecast.

A. Select the Explicit forecast period

 Usually 5- 15 years
 Condition business reach a steady state at
the end of the period
 Theoretically-Choice and length have no effect
on value
 Practically –indirect effect on value
Eg- return on new invested capital >cost of capita
during explicit period & equals thereafter
B. Free cash flow to the firm (FCFF)
 Sum of all cash flows to all investors
(debt+equity)
 Also called financing flow
 FCFF = operating free cash flow (FCF)
+
non operating cash flow
FCF = NOPLAT (NET OPERATING PROFIT LESS ADJUSTED TAXES)
– net investment

NOPLAT = EBIT – taxes on EBIT

Net investment = gross investment – depreciation

or
net FA &CA at end of the year
- net FA & CA in beginning of the year

Non operating cash flow arises from extraordinary items like profit from sale
of assets, restructuring expenses and payments for settling legal disputes
(adjusted for taxes)
C. Develop the free cash flow
forecast

 Corporate value is based on future cash flow

Therefore forecast P&L and Balance sheet for
explicit period

Checklist
 Develop a credible sales forecast
 Rely on complete projections
 Treat inflation consistently
 Look at multiple scenarios
STEP 2. COST OF CAPITAL
 The discount rate used to convert the expected
free cash flow into its present value.

Conditions
 Weighted average of all sources of cost of capital
 Post tax terms
 Based on market value
 Reflects the risks borne by various providers of
capital
WACC= r {e} (S/V) + r{p} (P/V)+r{d} (1-T) (B/V)

Where
WACC- weighted avg cost of capital
r {e}
S- market value of equity
V- market value of firm
r{p}- cost of preference capital
P- market value of preference capital
r{d}- pre tax cost of debt
T- marginal rate of tax applicable
B- market value of interest- bearing debt
While calculating -Weights are provided according to market value
STEP 3. CONTINUING VALUE
 It is value the explicit of free cash flow beyond forecast
period
assumptions
 Earns a fixed profit margin
 Constant rate of return on capital
 Reinvestment rate is constant
 Growth rate is constant

Steps
1. Choose an appropriate method
2. Estimate the valuation parameters & calculate the
continuing value.
 Growing free cash flow perpetuity method
CV t = (FCF t+1) / WACC –g
 Value driver method
CVt = [NOPLAT t+1 ( 1-g/r)] / WACC –g
 Replacement cost method
 Market to book ration method

Where
CVt = continuing value at end of the year t
g- expected growth rate for free cash flow for ever
R- expected rate of return on net new investement
STEP 4 .FIRM VALUE
 Is sum of following 3 components
1. PV of Free Cash Flow during the explicit
forecast period
2. PV of continuing value at end of explicit forecast
period.
3. Value of non operating assets , which were
ignored in the free cash flow analysis
THANK YOU