Zoom on Bridge EV - EqV

Understanding Enterprise Value (EV) and its key components is crucial for mastering financial valuation, especially in the context of M&A transactions. This article breaks down the essential concepts and adjustments needed to calculate EV effectively.

Definition of Enterprise Value (EV)

Enterprise Value (EV) represents the total value of a company, including its equity, debt, and various adjustments to reflect its operational reality.

Formula:

EV = EqV + Net Debt = Market Cap + Net Debt = Number of Shares (NOSH) * Share Price + Net Debt

⚠️ When Company A acquires Company B, A is acquiring the Enterprise Value (EV) of B. However, if A pays the EV of B, it would also be paying for B’s debt. This means A would effectively pay the debt twice. Therefore, when A acquires B, A acquires the EV but pays only the Equity Value (EqV).

Complete Formula for EV

EV = Equity Value (EqV) + Debt (short-term, long-term, current portion of long-term debt)  + Non-Controlling Interests (NCI) + Preferred Securities + Leasing Obligations + Other Non-Operating Liabilities (Provisions, Pension Funds) - Cash and Cash Equivalents (C&CE) - Investments in Associates

Non-Controlling Interests (NCI)

NCI represents the portion of a subsidiary’s equity owned by minority shareholders (e.g., if the parent company owns 80% of a subsidiary, the remaining 20% is NCI).

Why NCI is added to EV:

• EV reflects the total value of the company, including 100% of the subsidiary’s performance.
• Adding NCI ensures alignment with financial metrics like EBIT or EBITDA, which also account for 100% of the subsidiary’s contributions.

Preferred securities

Preferred securities, similar to debt, can dilute equity and impact EqV. 

For example:

• If options have a strike price of €80 and the share price is €100, EqV increases by €100 while debt decreases by €80.
• The EV is impacted by €20, requiring an adjustment.

Leasing obligations

Leasing obligations (or rental contracts) are added to EV in the bridge to reflect the company’s total financial commitments, including those not classified as traditional debt.

Why Leasing is Added to EV:

• Economic Debt: Leasing, especially operating leases, represents future payment obligations and is treated as economic debt.
• IFRS 16 Compliance: Since the adoption of IFRS 16, most leases are recorded as liabilities on the balance sheet, making them comparable to traditional debt.
• Alignment with EBITDA: EV must align with financial indicators like EBITDA, which is calculated before lease payments. Including leases in EV ensures the full scope of financial commitments is reflected.

Pension fund adjustment

A company’s pension fund reflects its obligations toward retired employees:

• Pension Liabilities: Total obligations owed to retirees.
• Pension Assets: Investments set aside to meet these obligations.

Impact on EV:

• Deficit (Liabilities > Assets): Added to EV as it represents an obligation.
• Surplus (Assets > Liabilities): Subtracted from EV, reflecting excess assets benefiting shareholders.

Investments in associates

Investments in companies where the influence is significant but not controlling (20%-50% ownership) are subtracted from EV. These investments represent external assets unrelated to the company’s core operations.

Fully Diluted Equity Value

Fully Diluted EqV accounts for the impact of dilutive instruments such as stock options.

Treasury Stock Method:

1. Assume all exercisable options are exercised.
2. Calculate proceeds from exercising the options: Average Strike Price x Number of Options Exercised.
3. Use the proceeds to buy back shares on the market.
4. Adjust the total number of shares after the buyback.

⚠️ This method applies only to stock options, not convertible bonds.

Common questions about EV and the Bridge

What is the impact of dividends on EV?

Dividends have no impact on EV:

After dividends are paid:

EV = EqV - Dividends + Debt - (Cash - Dividends) = EqV + Debt - Cash

Thus, EV remains unchanged.

Can a company have a negative Enterprise Value?

Yes, a company can have a negative EV, which occurs when cash exceeds the combined value of EqV and debt.

Common Scenarios:

• High Cash Levels: The company holds excessive liquid assets.
• Low Equity Value: Low market capitalization due to poor performance or undervaluation.
• Minimal Debt: The company has little to no debt on its balance sheet.

Negative EV is common in distressed companies or those with significant cash reserves but weak equity performance.