Enterprise Value: Why You Add and Subtract Certain Items (Version 2.0)

In this revised and updated lesson, you’ll learn about how to decide which items go into the Enterprise Value calculation, and which items you can safely ignore.
Resources:
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Table of Contents:
0:00 Introduction
5:26 “Always” Items
8:21 “Never” Items
11:01 “More Complicated” Items
14:50 “Maybe” Items
19:16 Recap and Summary
Lesson Outline:
Since Enterprise Value represents a company’s Net Operating Assets to all investors, and Equity Value represents its Net Assets only to common shareholders, you can move between them by adding and subtracting line items from the Balance Sheet (sometimes with adjustments).
You add any Liability & Equity line items that represent additional investor groups beyond the common shareholders, and you subtract any Assets that represent non-core or non-operating items.
Typically, this means that you subtract Cash, Financial Investments, Equity Investments, Net Assets Held for Disposal, and Net Operating Losses.
None of these is required to operate the company’s day-to-day business except for some minimum level of cash (which is ignored for simplicity).
You add items like Debt, Preferred Stock, Noncontrolling Interests, Unfunded Pensions, and sometimes Leases because all these items represent additional outside investors (or could be argued to represent additional investor groups).
With the standard items, such as Cash, Debt, and Preferred Stock, it’s quite simple: go to the company’s most recent Balance Sheet and get the values. If you have time, you can also search the filings for the “Fair Value” or “Fair Market Value” of items like Debt, as they sometimes differ from the figures on the Balance Sheet.
You should never add or subtract items that are part of the company’s Working Capital, long-term operational assets (Net PP&E, Goodwill, etc.), accrual items that represent timing differences, Lease Assets of any type, or industry-specific items such as Content Assets for Vivendi.
A few items are more complicated: if the Net Operating Losses have not already been tax-affected, you should multiply the total off-Balance Sheet figure by the Tax Rate to do that before subtracting them, as this represents the company’s actual savings from these items.
With Unfunded Pensions, you add Pension Liabilities - Pension Assets as long as Pension Liabilities are bigger - but the tax treatment differs.
If contributions into the plan are tax-deductible, as is usually the case in the U.S., you multiply this number by (1 - Tax Rate) to reflect the tax savings the company will realize by contributing to fully fund the plan eventually.
If not, as with many European plans, you do not multiply by (1 - Tax Rate), as contributions will not reduce the company’s cash taxes.
Finally, there’s a whole category of “Maybe” items, such as Leases, Restructuring/Legal Liabilities and Deferred Tax Liabilities.
We believe the typical rationale for the latter two (“they could represent large cash outflows!”) is weak because these items do not actually represent outside investor groups in the same way that Debt does (for example). These are also not interest-bearing liabilities.
Leases are more of a grey area, and it’s acceptable to add all Leases, exclude all Leases, or add just Finance Leases but not Operating Leases as long as you’re consistent with the metrics and multiples.
Specifically, if the denominator, such as EBITDA, excludes the Lease Expense, make sure you add the corresponding Lease Liability in Enterprise Value, and vice versa if it deducts the Lease Expense.
Adjustments may be required for metrics such as EBIT that deduct only part of the full Lease Expense.

[@financialmodeling]

Files and Resources: youtube-breakingintowallstreet-com.s3.amazonaws.com/106-20-Enterprise-Value-Why-Add-Subtract-Items-Slides.pdf youtube-breakingintowallstreet-com.s3.amazonaws.com/106-20-Steel-Dynamics-Vivendi-TEV-Calculations.xlsx youtube-breakingintowallstreet-com.s3.amazonaws.com/106-20-STLD-10-K.pdf youtube-breakingintowallstreet-com.s3.amazonaws.com/106-20-STLD-10-Q.pdf youtube-breakingintowallstreet-com.s3.amazonaws.com/106-20-Vivendi-2020-Earnings.pdf youtube-breakingintowallstreet-com.s3.amazonaws.com/106-20-Vivendi-2021-1H-Earnings.pdf

[@AlexKurinnyi]

this is by far the best channel on related matter on KZbin. thank you for what you are doing and how you are doing it

[@financialmodeling]

Thanks for watching!

[@ironmaidenfanish]

Thanks a lot for every single video that you uploaded for us! Greetings from India! :)

[@financialmodeling]

Thanks for watching!

[@christiancoronado]

Really good video, thank you!

[@financialmodeling]

Thanks for watching!

[@TheJaebeomPark]

nice summary!

[@financialmodeling]

Thanks for watching!

[@keiichithr]

Thanks always for the great video. I was wondering why the HF case study video was deleted recently, are there any chances of being reuploaded sometime in the near future? Hoping to see it again! Many thanks.

[@financialmodeling]

It was deleted because we have example stock pitches and a full guide there: www.mergersandinquisitions.com/stock-pitch-guide/ and the HF case study example really added nothing over all the other DCF and stock pitch coverage. Also, the modeling practices used were quite poor and don't match current standards.

[@k.c.krishna9570]

Explanation is really amazing... I wish u had given the formula for enterprise value

[@financialmodeling]

The 4th slide here explains how to move from Equity Value to Enterprise Value.

[@niklaswellmanns5052]

Awesome video! Yet, I am still a bit puzzled about the EV/EBIT multiple with regards to finance leases. As you correctly mentioned, EV/EBITDA is no problem if we capitalize leases, because the profit metric excludes the full lease expense. But when combining that same EV with EBIT, we essentially subtract part of the lease expense (the depreciation) but leave in the interest component all while still capitalizing the full lease liability. Not sure what the best approach is here. If we add back depreciation we would no longer have a true EBIT, if we subtract the interest component we exclude the full lease expense but still capitalize the full liability. Would it be best to use EV without any capitalized finance leases when calculating EBIT multiples? Would love to hear your insight!

[@financialmodeling]

Under IFRS, you need to adjust EBIT by deducting the Interest element of the Lease Expense. It's much less of an issue under U.S. GAAP because the Interest element of Finance Leases is small, and most companies have minimal or no Finance Leases, so most people ignore this.

[@domvk3082]

@@financialmodeling Don't get the logic

[@yohanmalet2372]

Great video! I was wondering if you knew the difference between redeemable non-controlling interests and non-controlling interests? I recently cam across those and I could not find a good enough definition for the redeemable NCI. Thanks in advance for the help :)

[@financialmodeling]

It's covered in our Real Estate course... it relates to certain corporate structures and the ability for the parent to change its stake in other entities.

[@lelioshmelio]

Brian, I have one question related to non-recurring charges. In separate video when calculating EBITDA you mentioned that we may add back non-recurring charges. But if in EV/EBITDA multiple we exclude such charges from EV, wouldn't it be incorrect? Or in historical periods we add them both in numerator and denominator, and in forecast projections do not pay attention? Thank you for great videos!

[@financialmodeling]

Non-recurring charges rarely correspond directly to a specific item in the Equity Value/Enterprise Value bridge, so this point doesn't really matter. For example, you might add back a Goodwill Impairment... but Goodwill is not part of the bridge anyway, so adding back or not adding back the Impairment doesn't make a difference in the Enterprise Value calculation.

[@sonerguney3225]

Many thanks. Super presentatıon. Can we have the files to download? Thanks

[@financialmodeling]

Click "Show More" and scroll to the links.

[@vincentnguyen6833]

Hi Brian, great video. Regarding subtracting cash, I understand that it's a non-operating asset, but another reason I've heard is that it can be used by the buyer to repay debt, effectively reducing the purchase price. Do you agree with this train of thought? Wouldn't a more reasonable explanation for subtracting cash be that since the seller keeps the cash usually, the buyer pays less because they don't keep that cash. Alternatively, the seller uses that cash to repay debt which reduce the amount of debt required to be refinanced (as most deals are negotiated on a cash-free/debt-free basis).

[@financialmodeling]

Cash does not "cancel out" Debt because not all Debt can be repaid early, or even if it can be repaid early, there are often penalties associated with it. So, no, I don't think that's the best reasoning. It's better to think of it as Cash reducing the effective purchase price, but that's still not the real reason.

[@benwillert480]

Do we subtract Passive Investments in other businesses (i.e. holdings accounted for by FV method, (less than 20% ownership))?

[@financialmodeling]

Yes, they are considered non-core assets.

[@jamesspencer3392]

Hi, thanks for the video. I was wondering about "other non-current liabilities." I noticed you did not add it, but I thought these were typically made up of smaller debt liabilities. Thanks for the help.

[@financialmodeling]

You have to check the filings and see what they include. If they include debt, yes, count them in the calculation.

[@matteok95]

Great video! What about financial derivatives ?

[@financialmodeling]

Depends on the company. For something like an oil & gas company using derivatives to manage exposure to commodity prices, they are probably *not* non-core and so should not be subtracted here. But if it's a tech company with too much money that wants to boost its returns by playing in the stock market, sure, derivatives are non-core in that case.

[@jl7702]

When calculating equity value from enterprise value, shouldn't you add back NWC (i.e. add AR and inventory less AP, etc.)? The argument being that for 2 companies that have the same EV, if one of them has higher AR and inventory, it should have a higher equity value than the company that has less (and vice versa for AP)? Similarly, can't you argue that you should add PPE? For example, if 2 companies were exactly the same, but one has much better real estate/property, the one with better real estate/property should command a higher equity value.

[@financialmodeling]

No. The bridge only reflects items that DIFFER between Equity Value and Enterprise Value, i.e., the items that are in one of these but not the other. Equity Value is the market value of Net Assets, and Enterprise Value is the market value of Net Operating Assets. Net Working Capital counts within both Net Assets and Net Operating Assets, so it is a part of both numbers and should therefore not be in the bridge. The same goes for PP&E: it's always a part of both numbers.

[@fatemeazizi1863]

Why is understanding the total debt and market cap crucial in EBITDA?

[@financialmodeling]

Not sure I understand your question. EBITDA is independent of capital structure and corresponds to all the investors in the company. Market Cap and Total Debt only matter in terms of the valuation multiples based on EBITDA, EBIT, and related metrics and making sure that the numerator and denominator are consistent.

[@rubbersoul246]

Why would a company like Opendoor subtract inventory (namely, properties that they’re holding on their balance sheet) as part of their EV calculation?

[@financialmodeling]

This would make sense only if they consider this "inventory" a non-core asset, which is unusual since Opendoor's whole business model relates to buying and selling properties.

[@purudate4049]

We may not have to do hair twitching. You take total liabilities from the balance sheet. Then, replace equity (including retained earnings) with its market capitalization. Then, replace debt with its market value to get the gist of EV. Then, we deduct non-core elements such as Cash, Cash Equivalent, Investments, assets held for sale to derive Enterprise Value

[@financialmodeling]

??? I'm not sure what your question is. However, "Total Liabilities" do not factor into Enterprise Value because some Liabilities are operational rather than financial in nature. The starting point for Enterprise Value is Equity Value or Market Cap, and then you add Debt and non-operating liabilities and subtract Cash and non-operating assets.

[@purudate4049]

@@financialmodeling Sir ! Let's take a case of acquisition. The acquirer ought to own all liabilities no matter operating or otherwise. Hence, you replace equity and reserves with market capitalisation, ascertain market value of debt and then proceed further

[@financialmodeling]

@@purudate4049 Yes, sure, but again, the "Total Liabilities" are not a part of the true acquisition price, which is the Purchase Enterprise Value. The buyer is paying for the Net Operating Assets of the seller, not everything it has. The buyer does end up with all the seller's Liabilities, but they only contribute to the Purchase Equity Value, not the Purchase Enterprise Value.

[@domvk3082]

15:02 - why so you have to deduct the interest element?

[@financialmodeling]

EBIT deducts the full Depreciation expense on both owned PP&E and leased assets, but it does not deduct Interest from any source (Cash or PIK interest on debt, amortization of OID and financing fees, lease interest, etc.). The rule with valuation multiples is that if you're adding a liability in the Enterprise Value numerator, you need to add back or exclude the full expense corresponding to that liability in the metric used in the denominator. And if you're not adding a liability in Enterprise Value, then you need to deduct the full expense corresponding to that liability in the denominator. So, if you add the Finance Lease liability to Enterprise Value, you need to add back the Lease Depreciation to EBIT so that your valuation multiple is: (Enterprise Value Including Finance Leases) / (EBIT + Finance Lease Depreciation) And if you do *not* add the Finance Lease Liability, your valuation multiple should be: Enterprise Value Excluding Finance Leases / (EBIT - Finance Lease Interest) If you do not deduct the Finance Lease Interest here, EBIT is inaccurate because it deducts only part of the full expense associated with the Finance Lease Liability. But it needs to be all or nothing for the valuation multiple to make sense.

[@domvk3082]

@@financialmodeling Great Answer! I appreciate it

[@iambaa9048]

I learned that you should always add the working capital because it will increase the EV which will lead to a higher equity value or purchase price

[@financialmodeling]

Not true. It depends on the context, how the deal is structured, and if it's a standalone valuation or the valuation of a target in a deal. Even if there is a Working Capital adjustment as part of the deal structure, it shouldn't change the total amount the buyer pays for the seller... it just shifts the Purchase TEV based on the Working Capital surplus or deficit, so that the shareholders might receive more or less, but the total price paid is the same.

[@iambaa9048]

@@financialmodeling If it shifts the Purchase TEV, then wouldn't that mean that the final total purchase price will be different? I emailed asking the question and I have put in numbers to illustrate my thoughts. It would be good to get a response, thank you very much.

[@financialmodeling]

@@iambaa9048 The "price" will be different but the total amount the buyer or PE firm pays to do the deal will be the same because when the official purchase price is lower, the buyer needs to contribute more to fund the Working Capital. So they are paying the same amount, but less of it is going to the company shareholders, and the official price used to calculate multiples will be lower.

[@iambaa9048]

@@financialmodeling What do you mean by the price would be different but the amount paid would be same? Could you perhaps use numbers to illustrate this or reply to my email query? Thank you