Understanding the Difference and Why Cash Matters
Share valuations often begin with an assessment of enterprise value (EV) as a first step in arriving at equity value (EqV). While these concepts are closely related, they are frequently misunderstood, particularly when it comes to the role of cash.
This article explains what enterprise value and equity value represent, how they relate to one another, and why cash treatment is critical in arriving at a conceptually sound valuation.
To discover more, please call us on 0330 118 8200 or Make An Enquiry
What Is Enterprise Value?
Enterprise value measures a company’s total value and represents the theoretical cost of acquiring the entire business, including both equity and debt.
Because EV is capital structure neutral, it allows for more meaningful comparisons between companies operating in the same industry, where capital expenditure levels and the use of debt are broadly comparable.
How Enterprise Value Is Commonly Calculated
Market-Based Valuation Using Earnings Multiples
Enterprise value is often estimated by applying a valuation multiple to an earnings measure. The most commonly used metric is Earnings Before Interest, Tax, Depreciation and Amortisation (EBITDA), although EBIT or other measures may also be used.
For example, a company with an EV of £5 million and EBITDA of £1 million has an EV to EBITDA multiple of 5. That multiple can then be applied to comparable companies, subject to appropriate adjustments for differences in risk, scale, or operating profile.
Discounted Cash Flow Method
Enterprise value may also be estimated using a discounted cash flow method. Under this method, future cash flows available to both equity and debt holders, after capital expenditure and tax, are discounted to their present value.
Enterprise Value in Transactions
Enterprise value is often the headline price announced in a transaction. At completion, it is adjusted for actual levels of cash, debt, and other agreed items such as surplus assets or differences between targeted and actual working capital. These adjustments result in the equity value ultimately paid to the seller.
What Is Equity Value?
Equity value represents the value of the shares alone. It reflects what the shareholders ultimately receive after taking account of the company’s debt and cash position.
The Relationship Between Enterprise Value and Equity Value
Whether EV is derived using market multiples or discounted cash flow analysis, understanding the relationship between EV and EqV is essential.
The relationship can be summarised as follows:
- Equity value equals enterprise value less debt plus cash
- Enterprise value equals equity value plus debt less cash
While the role of debt in these equations is generally well understood, the treatment of cash is often misunderstood.
Why Cash Is Included in Equity Value but Not Enterprise Value
Enterprise value represents the current value of future net cash flows generated by the business. These cash flows will be distributed between debt and equity holders.
Enterprise value does not include a positive figure for cash already held by the company, nor does it deduct debt that is currently due. It ignores both the cash inflow that would arise from extracting cash and the cash outflow required to repay existing debt.
Equity value, however, reflects the cash position of the business. Cash is available to shareholders, either through dividends or by reducing debt and increasing the equity share of enterprise value.
As a result:
- Cash is reflected in market capitalisation and therefore in equity value
- Cash must be removed when calculating enterprise value
- All else being equal, a higher cash balance indicates a lower enterprise value and vice versa
Common Pitfalls in Adjusting Cash
The Misconception of Surplus Cash
It is sometimes suggested that only surplus cash should be adjusted when moving from enterprise value to equity value, after allowing for cash needed in the business. Conceptually, this is incorrect. All cash should be treated as a surplus asset.
If the business requires cash post-acquisition, it can be introduced through borrowing, which is neutral from an equity value perspective.
Exceptions to Full Cash Adjustment
There are limited circumstances where not all cash may be adjusted, including:
- Where working capital has been manipulated to create an artificially high cash balance, such as by delaying creditor payments
- Where cash is trapped, for example in a foreign jurisdiction from which it cannot be extracted
These situations require careful forensic analysis.
Final Considerations in Share Valuation
From estimating enterprise value to bridging from enterprise value to equity value, valuation involves a range of subjective judgements. These judgements must be made within a conceptually sound framework to ensure the valuation is robust, defensible, and appropriate for its purpose.
To discover more, please call us on 0330 118 8200 or Make An Enquiry
Frequently Asked Questions
1. What is the difference between enterprise value and equity value?
Enterprise value represents the total value of the business, including debt and equity. Equity value represents the value of the shares after adjusting for cash and debt.
2. Why is enterprise value described as capital structure neutral?
Enterprise value excludes the effects of how a business is financed, allowing more consistent comparisons between companies with different debt and equity structures.
3. Why is cash added back when calculating equity value?
Cash is available to shareholders and is already reflected in equity value. It is excluded from enterprise value, so it must be added back when moving from EV to EqV.
4. Is cash always treated as surplus in a valuation when the starting point is enterprise value?
Conceptually, yes. All cash should be treated as surplus, unless there are specific circumstances such as trapped cash or manipulation of working capital.
5. Why is cash often misunderstood in valuations?
Cash does not form part of future operating cash flows but directly affects shareholder value, which leads to confusion when bridging between enterprise value and equity value.
“Thank you ever so much for the work and advice you have provided . The report was clear and accessible and will not hesitate to recommend you all.”
“I am indebted to you for your contribution, and for explaining things in plain English such that even lawyers can understand the issues”
“May I take this opportunity to thank you for your assistance in this matter. Counsel and the judge said that your report was one of the best they had seen in that it was concise and technically easy to understand.”