Enterprise Value Question

Sometimes analysts will adjust Enterprise value to include accounts receivables (depends on liquidity, and yes there are people who buy accounts receivables for cash), and I am sure if there was a significant amount of Accounts payable (something that would have a material difference in the value) it would be adjusted for as well. Otherwise, equity value + net debt + minority interest + preferred stock is used as an easy way to see (as you mentioned) how much should be paid for the firm.

In the real world, analysts will use public comps, acquisition comps, dcf, and lbo to get values, and then accretion/dilution analysis to see the impact of a merger on the new company. For the two comp sets, Enterprise Value is a quick and useful tool to get your multiples. For the DCF and LBO, accounts payable would be incorporated in your Free Cash Flow calculation and ultimately into your enterprise value. Finally, accretion/dilution will show you the full blown effect of the accounts payable on the new company's EPS. Theoretically, it should be included but the function of Enterprise Value is to provide a quick and easy answer.

Hope this helps, maybe someone will come along and confirm it or rip it to shreds.

think zip is pretty spot on here. first of all yes to be completely accurate yes A/R and AP would be included but most companies have 30-90 day periods so outstanding AR and AP will be gone by the time the acquisition is consumated. also, for many of the companies i look at, there are significant legacy liabilities (pension, OPEB, environmental) which generally rank pari with unsecured debt and are added in the enterprise value calculation.

secondly, yes analysts typically use what is known as a "football field", combining comps acq compds, dcf, multiples etc.

Thanks. That helps.

"so enterprise value is the minimum amount you should pay for a firm" -- why do you think so?

Best,
SoulSearching

I'm no expert but wouldn't things like ap be factored into the equity value?

Isn't the point of enterprise value to find the purchase price of the company's core operations if you were to retire the debt? In that case I don't think AR and AP would be included. Say you had two companies - exactly the same - except one had $100 million more in A/R. I would think their market cap would be roughly $100 million more. The same is true with debt, but I think you are looking at what the company would look like without that debt. I'm just a summer so please correct me where I'm wrong.

Equity value is an open-ended call option on the Enterprise Value of the firm.

that's BS

...no it's not.

But perhaps you'd like to enlighten us as to why you think it is?

Equity value = stock price (* no of shares outstanding), and the stock of the company is not a call option on the enterprise value of this very company. This is absolute BS.
Besides, buying the stock, you pay its full price (rather than an option premium).
Then, if we for a minute imagine your statement were true, we would need to have accepted that enterprise value may be considered an underlying (on which an option is written). This is not that easy - on the contrary to the equity value (or MCap), EV is not as clearly defined (so that in different cases, some portions of liabilities may or may not be considered parts of net debt, for example).
Then, with options, buyer doesn't have any obligations (only rights - after he has paid the premium), while writer has only obligations, but no rigghts (after he has received the premium). With stock, it is not so: buyer of the stock (i.e. shareholder) has both righths and obligations.

And so on, and so forth - i.e. your statement is absolute BS.

Typically working capital will need to be maintained within a certain range up to the close of the transaction. This is to keep a seller from selling off all their inventory and collecting all accounts receivable while holding off on paying any bills.

Most of the deals I have seen (which doesn't amount to too many), the buyer will give a range that working capital will need to be within at the time documents are signed and funds flow. If working capital falls out of this range, adjustments are made at close.

Hope this helps.

That is true and, yet, is in no way incongruous with my statement.

Just because you say it doesn’t make it true.

Consider the share price as the premium itself. If the Enterprise value goes up and the debt stays the same then you can sell these “call option” onto someone else. Alternatively, if the company goes bust then your “options” (shares) become worthless. But you never lose more than your premium – just like a call option.

Why not? Is there any other asset in the world that you would buy without giving consideration to the total amount that you have to pay to acquire that asset. When you buy a house, do you ignore the fact that there’s a million dollar price tag on a hovel in Detroit because you only have to put $100 down? Or would you pay $1000 for a can of coke because you can pay 2 cents now and finance the rest? Didn’t think so.

On the contrary, it’s very simple – EV is the value of the firm. Whether you want to base that on the market-implied calculation, or a peer comparison is up to you. But that’s what it is.

Like a shareholder – who doesn’t have any obligations beyond the “premium” that has been paid for the shares.

Like a short-seller of stock. If you trace it back to the root (the primary equity issuance), the company has foregone part of its future upside to its own enterprise value in order to get some guaranteed money up front.

Maybe I have been remiss in my duties as a shareholder. What obligations do I have other than what it cost me to buy the shares (“premium”)

Get back to me when you’ve thought things through a bit rather than automatically dismissing anything that doesn’t exactly match what you were taught in school.

Like it or not, but eqiuty value is "the value" which has ultimate importance, not EV. If you were talking about ways in which we could consider the EV a call option on the equity value, it might have been another story. It would have even made sense: via maximizing the value of the business we try to achieve the main task - i.e. maximize the value of the firm for its shareholders. Actually, that's what is being done in reality: people employ various business models, use leverage when it is economically efficient, undertake M&A transactions etc - all in order to increase the value of equity. But vice verca, in your interpretation, it doesn't make economic sense, in my opinion.

Also, I would ask that you change your tone: I am not a student who's a "banker wannabe" and have rather decent track record. Whether or not you have enough under your belt to talk to me in such tone, I am not sure.

I take it all back then. On second thoughts, no I don't. If you disagree with me without any kind of reasoned discussion, I'm going to call you out on it.

I'll refer you back to a point in my previous comment - so you would buy a house without reference to the total price, only what you have to put down as a deposit? Or to bring it directly to the case in hand, you would buy shares in a company without consideration of its balance sheet structure?

That is the most asinine thing I have read today - and that really is saying something....

...compounded by the fact that you actually seem to believe it.

That only takes place AFTER you have decided what the Enterprise Value is.

Please, please, please just think about what you are saying here. You are infecting the world with your stupid.

My tone? I set forth my argument, which you call bullshit on without any reasoned justification why. I think it's your tone that need adjustment.
I'm sure you're very proud of your track record, as am I - and I was made a VP five years ago so if you want to play the dicks on tables game then go right ahead. That's not what I was talking about though - my point was that you shouldn't automatically dismiss a point just because it's what you've been indoctrinated into thinking.

So I'll say it again: Get back to me when you thought things through a bit and want to come back with an intellectually rigorous argument.

the funn thing is that you have not set forth any argument, you've wrote a statement.

When an investor buys 100 shares in the company, he pays for equity value, not for EV. and when time to sell comes, the return of this shareholder will again be determined by its equity value. Definitely, this investor considers financial, as well as all other factors, but all these factors are already accounted for by the market and are thus in the stock price (of course market is not 100% efficient, but at least on developped markets with high liquidity it is significantly efficient).

What is more, when hedge funds \ institutional investors influence the momentum of the share price by buying\selling large volumes (sometimes even manipulating the market) - they again do not care about EV, as profits from trading operations arise from differences in stock prices, not EV.
Actually, for any financial investor equity value is the ultimate figure. For strategic investor entering M&A transaction it might be somewhat different - as this investor may wish to gain a certain level of control over acquired assets, so that to (possibly) influence management decisions (like, for example, usage of leverage).

With regards to buying a house: there are 2 main options - to buy a house with 100% cash payment or with a mixture of cash and debt. Which one to choose depends on market conditions and personal preferences\circumstances. And regardless of what one chooses, finally, upon disposal, he will care about net gain of the operation, which will be represented by the change of one's net worth (total amount of money he receives minus total amount of money he has paid, after making all required debt repayments and such).

there's a lot of noise (read: garbage) in many of the above posts. Enterprise Value reflects the fair market value of the OPERATIONS of the firm attributed to ALL providers of capital. Shareholders are one type of providers of capital and therefore equity value (market cap) is one component of enterprise value. whether one looks at enterprise value or equity value depends on one's purpose. having said that, even if you want equity value (e.g. you are an equity research analyst or investor in stocks) it is always better to value the equity by first valuing the enterprise (then subtracting debt, etc.) rather than by valuing the equity directly. the debt in the EV formula only includes interest bearing debt and does not include accounts payable or other operating liabilities.

enterprise value is NOT the minimum amount one pays for a firm.

Ivan,
Whether I agree or disagree with what you wrote in your last comment is irrelevant as it has says nothing that questions my original assertion:

“Equity value is an open-ended call option on the Enterprise Value of the firm”

Now, with the exception of it being open-ended (and hence why I included this important point within my definition), please explain to me what characteristic of equity is incongruous with a call option?

You have also outdone yourself with your comment about “investors not caring about EV”. Up until that point, I just thought that you were misunderstanding what I have written but now I am seriously worried for the people that you “advise”.

And finally, just to be clear on what you wrote in your final paragraph. Can you confirm that you are saying that you would give no consideration to actual price of the house when deciding whether to buy, only how you would finance it? Because that is how it reads. And if the answer is “no”, then what you are saying is that you agree with me – once you get your head around it.

John Mack is correct.

Nb: It is not a used valuation technique in practice. However, one with a general education in finance should have seen this concept of valuation of equity using an option perspective.

Here's a quick link I found online for some intuition:
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/lectures/opt.html

No. You suggested that we take purchase of a house as an example - so writing above, I assumed that the decision to buy has already been taken (i.e. various factors like location, condition, price and many others were already considered beforehand). Definitely, all these things are important.

While equity can be viewed as a call option, I think the original statement is slightly off. Equity is a call option on the assets (with debt being the strike price) not the enterprise value.

my dick is huge, highly levered. so don't talk to me in a negative tone either.... just throwing that out there

You assume a lot, considering I wrote this originally:

then followed it up with this:

The point is, you work out what you think the value of the firm is first, THEN you work out the value of the equity. If you are taking the market cap and adding debt, etc., you are calculating the market-implied enterprise value. Comparing the two determines whether you think there is an investment opportunity.

That is true if we are talking about a company that is in liquidation (as discussed in the Damodaran link). However, if the company is still a going concern then the equity is a call option (an open-ended one) on the future profits of the firm. ie the Enterprise Value.

Dad?

Even if the company is a going concern, equity is not a call option for all future profits. Equity holders will only get the portion of the profits after debt holders get paid (interest).

John Mack's spot on.

Ivan - It’s better to keep your mouth closed and let people think you are an idiot, than open it and remove all doubt - Mark Twain

but John Mack has made a well-reasoned argument here.

What is funny, is that Mack says equty value (i.e. stocks) is a call option, while call option is a derivative financial instrument. One of the distinguishing features of any derivate fnancial instrument is that it is NOT a valuable security. stocks, on the contrary, are valuable securities by definition, and as such, they may not be considered a derivative instrument (though, of course, they may be an underlying to a call option).

He could not be more vague with his statements, and simply asks questions or disagrees without giving any substantial argument.

That's not funny. Nor is it relevant.