This article is written by Saswata Roy, pursuing Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from Lawsikho.

Introduction

In the context of M&A, stock investment, stock option assessment, leveraged buyouts (LBOs), financial research, and practically all other valuation scenarios, company values are critical. When calculating the company’s worth, it needs to be kept in mind that a company’s worth varies depending on who you ask. Here we will take into account two such groups – equity investors and other investors. Equity investors would refer to those investors who are owners of equity shareholders. Other investors include every investor like preferred shareholders, debt-holders, etc. 

What is equity value?

In simple terms, the equity value of a company refers to the value of the company in the eyes of equity shareholders. A company’s equity value is determined by the total number of outstanding shares and the current market price of those shares. Equity value is more commonly known as market capitalisation. The equity value or market capitalization of the corporation fluctuates because the current market price of shares is not constant. According to their market capitalization, companies can be divided into three categories. They are:

1. Large-cap company:  These are companies with a market capitalization of at least Rs. 20,000 crores. These are well-known businesses with a positive reputation. They’re less risky since they’re less volatile. 
2. Mid-cap company: Companies with a market capitalization of more than Rs. 5,000 crores but less than Rs. 20.000 crore fall under this category. These are more volatile than large-cap corporations and hence pose a greater risk. They also have a better potential for growth and hence attract more investors.
3. Small-cap companies: Companies with a market capitalization of less than Rs. 5,000 crores fall into this category. These companies are relatively smaller in size. They are extremely volatile and comes with a higher level of risk.

The equity value gives an overall idea about the company but not the exact value of a company.

What is known as enterprise value?

In simple terms, an enterprise value of a company refers to the value of the company in the eyes of all investors. The enterprise value of a company depends on many factors including equity value, preference shares, debt, minority interest and total cash and cash equivalents. Let’s discuss the different components.

1. Equity value: We have already discussed this above.
2. Preference Shares: These are hybrid stocks as they have features of both equity and debt. These shares have a preference in terms of payment of dividends as compared to equity shareholders and also carry a preferential right to be paid in the event of winding up of the company as compared to equity shareholders. 
3. Debt: It refers to various loans which a company takes from creditors and various financial institutions. Both short term and long term debt are included.
4. Minority interest: It is a part of a subsidiary that is not owned by any parent company. Typically, the financial statements of such a subsidiary are consolidated with the financial report of their parent company. Generally, the minority interest is added in the calculation of EV because the parent company includes the total revenue earned, expenses incurred and cash flow generated in its financial numbers.
5. Cash and cash equivalents: These are among the most liquid assets in a company’s financial statement. Cash and cash equivalents like short-term investments, commercial paper, marketable securities, etc. are subtracted from EV. It is done because they tend to lower the acquiring cost of a company.

The enterprise value of a company gives a more detailed picture than the market cap. The value of enterprise value stems from its capacity to compare organisations with various capital arrangements. Investors can obtain a better sense of whether a firm is actually undervalued by utilising enterprise value instead of market capitalization to assess its value.

How to calculate equity value?

The equity value of a company is calculated by multiplying its outstanding shares with the current market price of a share, i.e., the total number of shares outstanding * current market price of a share. 

For example, a company has ten lakhs outstanding shares and the current share price according to BSE is Rs. 100 per share. This the equity value of the company = Rs. (10,00,000 * 100) = Rs. 10,00,00,000, i.e., ten crore rupees. 

How to calculate enterprise value?

Enterprise Value is calculated by adding equity value, preference shares, debt minority interest and finally subtracting cash and cash equivalents. Thus, Enterprise Value = Common Shares + Preferred Shares + Market Value of Debt + Minority Interest – Cash and Equivalents.

Particulars	Amount (Rs.)
Current Market Price	20
No. of Outstanding Shares	500
Equity Value (20*500)	10,000
Preferred Shares	1,000
Long Term Debt	200
Short Term Debt	150
Debt (200+150)	350
Minority Interest	Nil
Cash and Cash Equivalents	200

Enterprise Value = Equity Value + Preferred Shares + Market Value of Debt + Minority Interest – Cash and Equivalents

Enterprise Value = Rs. (10,000+1,000+350+0-200) = Rs. 11,150

Equity value and enterprise value multiples

When valuing companies, analysts can create more accurate predictions by using multiples. This is especially true when multiples are employed correctly, as they convey useful information about a company’s financial position. Multiples are also important since they include key statistics that are pertinent to investing decisions. Finally, multiples are convenient to use for most analysts due to their simplicity.

However, because it simplifies complicated information into a single value, this simplicity can also be considered a drawback. This simplification can lead to misunderstandings and make it difficult to separate the effects of different elements. As a result, they demonstrate how a business develops or progresses. As a result, multiples represent short-term values rather than long-term ones.

Equity value multiples

Equity multiples are used in investment decisions, especially when investors are looking to buy minor stakes in companies. Some common equity multiples used in valuation calculations are listed below.

• P/E Ratio: The most often used equity multiple; input data is readily available; calculated as the ratio of Share Price to Earnings Per Share (EPS).
• Price/Book Ratio: If assets are the primary driver of earnings, this ratio is important; it is calculated as the ratio of Share Price to Book Value Per Share.
• Dividend Yield: Calculated as a proportion of Dividend Per Share-to-Share Price for comparisons between cash returns and investment types.
• Price/Sales: Employed for loss-making companies; rapid estimations; estimated as the ratio of Share Price to Sales (Revenue) per Share.

However, a financial analyst must consider that corporations have different levels of debt, which affects equity multiples.

Enterprise value (EV) multiples

• EV/EBIDTA: EBIDTA is Earnings Before Interest, Depreciation, Taxes and Amortization. EBIDTA = Earnings of the Company + Interest + Depreciation + Taxes + Amortization. EBITDA can be used to replace free cash flows; it is the most commonly used enterprise value multiple. This multiple can be used for the following purposes:

1. Valuation of capital-intensive businesses with substantial depreciation and amortisation.
2. Makes it easier to compare companies, even if their financial leverage is different. 
3. Makes it easier to compare organisations with diverse capital structures.

• EV/Sales: It’s a preferred ratio that takes into account the amount of debt that needs to be paid off. The lower this ratio is, the more undervalued a company, under scrutiny, is.
• EV/Invested Capital: It is calculated as the ratio of enterprise value to Invested Capital in capital-intensive sectors.

There are many more equity and enterprise value multiples that are utilised in company valuation; however, this article only covered the most popular ones. Analysts can better employ multiples in financial studies if they have a solid understanding of each multiple and related concepts.

Purchase price in M&A : equity value or enterprise value?

While many people believe that enterprise value represents the full cost of acquiring a firm, this is not the case. Enterprise value may be closer to the actual Purchase Price in some cases; however, this is dependent on the circumstances of the sale and the components included in enterprise value. It is true that in order to own 100% of a firm, you must purchase 100% of its common stock. In an M&A transaction, the purchase equity value serves as a form of floor price for the purchase price.

However, including the seller’s debt, preferred stock, and other funding sources and removing 100 percent of the seller’s cash balance does not actually establish the “true price”. The terms “equity value” and “enterprise value” are useful for valuing a company, but they are less useful for assessing the actual price paid.

Due to the treatment of debt and cash, fees, and obligations that do not affect the cash cost of making the deal, the real price paid may be between equity value and enterprise value, above them, or even below them, depending on the circumstances of the sale.

Conclusion

In a merger or acquisition, a business can be appraised in two ways: enterprise value and equity value. Both can be used to value or sell a business, but they provide significantly different perspectives. While enterprise value, like a balance sheet, provides an accurate measurement of a company’s whole current value, equity value provides a picture of both present and possible future value.

In most circumstances, a stock market investor or someone looking to buy a controlling interest in a firm will use an enterprise value to determine the value quickly and easily. Owners and present shareholders, on the other hand, frequently use equity value to help them make future decisions.

References

• https://www.mergersandinquisitions.com/enterprise-value-vs-equity-value/
• https://www.wallstreetprep.com/knowledge/common-topics-of-confusion-for-investment-banking-analysts/
• https://www.wallstreetmojo.com/equity-value-vs-enterprise-value-calculate-formula/

Students of Lawsikho courses regularly produce writing assignments and work on practical exercises as a part of their coursework and develop themselves in real-life practical skills.

LawSikho has created a telegram group for exchanging legal knowledge, referrals, and various opportunities. You can click on this link and join: