IB Prep - Equity Value/EV Questions

Key Rule #1: What is Equity Value?

Otherwise known as market cap, it is the share price of the company * the total shares. Answers on a surface level “how much is this company worth”

Key Rule #2: What is Enterprise Value

Enterprise value refers to the actual cost of buying a company, since it factors in adding things we need to set off funds to to pay off in the future and subtracting things we can save money on in the future.

Enterprise Value Calculation

Enterprise Value = Equity Value + Debt + Preferred Stock + Noncontrolling Interests - Cash & Cash Equivalents

Why is calculating the number of shares outstanding tricky?

Due to dilutive securities, the process by which there could be more shares created.

Dilutive Security Example

Call options, as they give an employee the option to pay money and get a newly created share in return.

Exercise Price

The amount an employee pays the company for receiving a share

Ex: 10 dollar stock, 5 dollar exercise price. Employee can pay 5 dollars and receive 1 10 dollar stock

Out-of-the-money vs in-the-money options

In-the-money options offer an immediate profit as the exercise price is lower than the share price, whereas in out-of-the-money options the exercise price exceeds the share price (and therefore cannot be exercised until the share price hits the exercise price).

Treasury Stock Method

Used to calculate impact of diluted shares, assumes new shares created when options exercises and the company buys back some of the shares with the funds it receives.

Sample Options Problem

Share price:10
Exercise price:5
100 options
All options exhausted

1. 100 options exercised at 5 dollar exercise price means the company makes 500 dollars.

2. The company uses those 500 dollars to buy back stock, and since the share price is 10 dollars, they buy 50 stocks.

3. There are now 50 additional shares outstanding, and diluted share count goes up by 50.

Convertible Bonds/Preferred Stock

Another form of dilutive securities, differs from options since it is a loan being given to company, said loan can traded for shares of company instead of being paid back with interest

Sample Convertible Bonds Problem

Share price: 100

Exercise price:50
$10 million convertible bonds
$1000 par value

1 million shares outstanding

1. Calculate individual bonds: 10 million convertible bonds/1000 par value = 10000 convertible bonds

2. Number of shares per bond calculation: 1000 par value/50 exercise value = 20 shares per bond

3. Convertible bonds (10000) times shares per bond (20) = 200000 new shares, so 1.2 million diluted shares outstanding

RSU (restricted stock units)

Dilutive Security, straight addition

Performance Shares

Dilutive Security, addition as long as the shares exceed a certain exercise price, otherwise worth nothing

Deductions for Enterprise Value

• Cash - Subtract cash that the company being acquired contains

• Short term/long term/equity investments - Can be subtracted depending on liquidity (public stock is more likely to be subtracted than equity in a startup)

• Net operating losses - Can be subtracted for tax deductions sometimes

Additions for Enterprise Value

• Debt, acquirer must pay off debt

• Preferred Stock, acquirer must settle the preferred stock when acquisition happens

1. Why do we look at both Enterprise Value and Equity Value

Equity value represents the surface level value of the business that is only available to shareholders (equity investors) whereas enterprise value represents the value attributable to all investors

Looking at both is important because Equity Value is what the public sees (“sticker price”) whereas enterprise value is what it would actually cost to acquire

2. How do you use Equity value and Enterprise value differently?

Equity value gives an idea of how much the company is overall worth whereas enterprise value gives an idea of how much it would cost to acquire

it also depends on the valuation multiple being used. If the denominator includes interest expenses (net income) we equity value whereas if it does not (ebidta) we use enterprise value

3. Enterprise Value Formula

Enterprise Value = Equity Value + Preferred Stock + Debt + Noncontrolling Interests - Cash & Cash Equivalents

4. Why do we add Noncontrolling interests to Enterprise Value?

When a company owns over 50% majority of another company, it must report 100% of the financial performance of said company.

Even though the company does not own 100% of the other company, it reports 100% of their revenue.

We have to add noncontrolling interests so that both the numerator and denominator of an EV/Revenue multiple represent 100% of the company.

If we did not, the numerator would not represent 100% of the company whereas the denominator would.

5. How do you calculate diluted shares and diluted equity value

Take the basic share count and then add the dilutive effect of any dilutive securities such as options, warrants, convertible bonds, RSUs

We use the treasury stock method to calculate the dilutive effect of warrants or options.

6. Why is share dilution important

It can more fully capture the cost of acquiring a company. In an acquisition scenario, the in the money securities will either be cashed out and paid by the buyer or converted into equivalent securities for the buyer which both raise the purchase price (as much as 5-10% which is important to note)

7. Why do we subtract cash from Enterprise Value

In an acquisition the buyer technically gets the cash of said company being acquired, so it technically pays less for the company depending on how large the cash reserves of the company being acquired are.

Caveat is not always accurate since technically we should subtract solely excess cash (the cash leftover after factoring in the minimum cash the company needs to operate)

The calculation for said minimum cash needed however is extremely complex and we need a standardized way to get Enterprise value among all companies.

8. Is adding debt to EV accurate?

Yes, because debt issuance terms hold that debt must be repaid in an acquisition and it is the buyer’s responsibility.

Its also standardization purposes, as adding debt to some companies and not some would make multiples inaccurate.

9. Can there be negative EV

Yes, it either implies that the company has enormous cash reserves or extremely low market cap. Usually seen with companies on the brink of bankruptcy or with large cash reserves.

10. Can there be negative equity value

This is not possible as both negative share price and negative share count are not possible.

11. Why do we add preferred stock to EV

It pays out a fixed dividend and preferred shareholders have a higher claim to the companys assets than regular equity investors. It is more similar to debt in this sense than common stock, and thus must be repaid in an acquisition scenario.

12. How do we count convertible bonds as part of EV

If they are in the money, we just add on the amount of shares that the bonds are worth to the equity value (no treasury stock method)

if they are out of money, then we count the face value of the bonds as part of the debt

13. Equity value vs Shareholder value

Equity value is the market value and shareholder equity is the book value. Equity value can never be negative since share count and price can never be negative, whereas shareholder equity can technically be negative if liabilites exceed assets.

In healthy companies equity value should exceed shareholder equity by a large margin, indicating the market value is much larger than the value on paper.

14. Should you use enterprise value or equity value with net income when calculating valuation multiples

Equity value, because net income represents the profit after interest expenses and is only available to equity holders.

15. Why do you use Enterprise Value for Unlevered Free Cash Flow multiples, but Equity Value for Levered Free Cash Flow multiples? Don’t they both just measure cash flow?

Levered Cash Flow includes interest income/expenses which means the profits at this point are exclusively for equity investors, hence why we use equity value here. Likewise, unlevered cash flow does not include interest income/expenses which means enterprise value is more representative as a whole here since creditors are still a part of the profit.