I have always failed to understand the true meaning of enterprise value. What I do know is how to construct a DCF, find out all the free cash flows, terminal cash flow, discount them and end up with an “Enterprise value”. I get confused when people tell me that this number inherits debt, and more confused when they say this is what I would pay for the company. I also get confused when they differentiate it to equity value.
Can someone please be a savior, consider me an amateur, and break it down for me in some simplified explanation?
Also, what is the difference between getting an enterprise value that way, and doing this: Enterprise Value = Market Cap + Debt - Cash?
Think of it this way - a company is financed by equity (owned by shareholders) and debt (owned by bondholders), in order to purchase the assets the company has for operations. If you buy a whole company, you need to purchase both the equity from the shareholders and the debt from the bondholders.
Also, you deduct cash, because deals are usually on a cash-free basis (or in the alternative you just pay for cash on a dollar-for-dollar basis, i.e. if a company is sold with 1 million in cash, you need to increase your price by 1 million as compared to the situation the company was sold without that cash).
When you’re buying a company, you will purchase company’s debts as well as its assets. If you are not smart enough, not just those debts evidenced in the BS. That’s why clever buyers usually take due diligence before acquisition. Although the diligence doesn’t provide an absolute assurance, just a reasonable assurance.
I think that you’re misunderstanding what is paid and to whom.
Suppose that the company’s assets total $100, with $60 in debt and $40 in equity.
You can buy 100% of the company for $40 cash. In that case, you inherit the debt and will eventually have to pay $60 to pay it off.
If you pay $100 for the company, then you get 100% of the company and pay off the debt immediately; i.e., $40 goes to the shareholders and $60 goes to the debt holders.
Reasonable assurance is provided in audit exercises, not due diligence. Due diligence reports do not express opinions with any kind of assurance (neither reasonable - such as given in audits, nor limited - as given in reviews).
Think of if like you’re buying a house for a rental property. You buy the house and finance it with a mortgage. If you value the stream of cash flows from this rental property before your mortgage payment then you need to subtract debt from your valuation. This is the FCFF approach. If you value the stream of cash flows after the mortgage payment then you are using the FCFE approach and do not need to subtract debt from your valuation. In this case there are two values to focus on. The value of the home is like the value of the company. The value of the home equity is like the value of stock.
This is irony. When you’re buying a firm, if you are not careful, you will end with debts, not just those recorded in the balance sheet. That’s the point.