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Enterprise value and Cash?

When calculating enterprise value you subtract cash but when calculating equity value you include the amount of the cash.   Why does it seem to be excluded from the total firm value but included if you are valuing the stock??

If i was the seller, why would i subtract the value of my extra cash when determining my total company value?  I wouldn’t just let you have it…wouldn’t i want the value of that cash included in the purchase price??

Thanks!


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Cash is already accounted in the equity value. If we don’t subtract cash from EV then it will be double counting. Subtracting cash effectively lowers the price for the buyer to acquire the firm.

How is cash already in the equity value, at least not extra cash?  If you added it, then that would be double counting.  

Just seems odd that in finding total equity value from EV, you subtract debt and add back cash…but you subtract it when calculating EV…what am i missing there?      I know excess/extra cash is always one of the last pieces to negotiate in a transaction, but if i was a business owner, assuming i leave enough in working capital, i would want to take that cash with me, and therefore included in my asking price…no?



EV is what someone would pay to acquire the firm. So for that purpose - the cash included in the EV is removed - assuming that the cash available is NOW with the acquirer and he would not pay for it (in that sense).


CP

CPK, but doesn’t that cash belong to the equityholders…don’t you include it in determining total equity value?   Just confused why you subtract it out for EV but add it back (and subtract debt) when finding equity value.

If you were a selling shareholder, wouldn’t you want your interest to reflect that extra cash in the value?

http://www.investopedia.com/video/play/understanding-enterprise-value#axzz1YQhtpMhp

how much you need to pay to acquire the firm does not include the cash that the company has on its books.

Market Cap + Market Value of Debt - Cash.

Cash that is present during the process of acquisition can be used to pay down the outstanding debt.

(effectively reducing the market cap of the firm).

CP

How does paying down debt reduce a firm’s market cap?

Any extra cash is effectively a non-operating asset.  Do you not add back that cash (and any non-operating assets for that matter) when going from EV to equity Value??   Just seems odd that the equity value there would be more valuable then the inital equity value in the EV, no??   SHouldn’t the market cap reflect that cash?

Thanks for the help, CPK

wow thanks CPK thats wonderful video…. i will never forget the concept now

CPK,

How does paying down debt reduce a firm’s market cap?

Any extra cash is effectively a non-operating asset.  Do you not add back that cash (and any non-operating assets for that matter) when going from EV to equity Value??   Just seems odd that the equity value there would be more valuable then the inital equity value in the EV, no??   SHouldn’t the market cap reflect that cash?

Thanks for the help, CPK

Think of it as what you would need for an all cash purchase of a company.  If you buy all of the stock, you’d also be on the hook for all of the debt.  So you have to add those two together.  Now you own the company; your actual cash outflow, however, will be less since you also own the cash and marketable securities of the company.  So you can now reduce your cash outflow by those amounts.

I guess I understand that to be the theoretical purchase price to acquire the company’s OPERATIONS.

But take Apple for instance…they have a boat load of cash on their balance sheet (which I know is the exception) but that cash is (should be) factored into Apple’s stock price.  If you subtract that cash, you are effectively reducing the stock price by the per share amount of that cash.  Do you think an Apple equity holder would sell for that amount…especially when it ignores the cash and the companies successful history of earning returns on that cash???

Guess there’s a disctinction btw EV, which is based on the value of the company’s operations, and equity value which might include cash and other non-operating asset/liability values…no?

A companies assets are valued at the market value of equity and the market value of debt (Assets = Liab + Equity).  The EV tries to capture this relationship to give you a theoretical cash purchase price of the entire company, not just operations.  To give you a simplified example, suppose I offer to sell you my car for $1,000 and tell you there’s $100 in the glove box for you to keep.  How much cash will you be out of pocket to buy my car? 

But you would be silly to either a.) not take the cash with you before sale or b.) not want to include that in the value of the car.  Unless the $100 is already priced into the $1,000, why would anyone sell a car (company) worth $1,100 (operations=$1000 + cash=$100) for effectively $900 ?

EV is solely for the operating value of the company, you are subtracting the cash/nonoperating component.

By the same token is an acquiring company going to be allowed to “take the 100$ cash in the glove compartment” (which is exhaust / liquidate the extra cash on its balance sheet by paying perks to its owners e.g.) and then sell the company - at the same price that it was valued at before?


CP

BMiller, Yep, that makes sense, I stand corrected.  It has to be for the operating value of the company.

I also wouldn’t look at it as Right side (debt + equity) of the balance sheet for Left side (assets) because if you subtract out cash/marketable securities then right side no longer equals left side.

I think the distinction and summary is this (CPK/others please confirm):

1.)  EV is essentially the “effective” value to acquire the on-going operations of a business.  I say “effective” bc (using the car example above) you would still pay the asking price of $1,000 but once you own/pay for the car, you’re net cash position is -$900.  So you “effectively” paid $900.  You don’t pay the EV of $900, which is effectively equal to $800 after purchase…doesn’t make sense.  You don’t pay the EV.

2.)  To CPK’s last point.  If you’re selling, you either distribute the cash pre-sale (take $100 out of glove compt) or ask for $1,100.  If you ask for and get $1,000, then the buyer could step in, pocket the $100 and sell the car immediately for the same $1,000 price for a profit of $100.

Cash is the last stop at the negotiating table, so some of this is moot and gets thrown around when determing the final purchase price.  Depends on working capital needs, history of reinvesting the cash, alternative investment environement, etc.   But as a seller, I wouldn’t let ANY extra cash just line the buyer’s pocket.  You either add it to the purchase price or don’t and let me take it on the way out.  Apple’s stock price most certainly includes the value of its FAT cash pile, therefore you are paying for that cash when you buy a share in apple.

CPK (others), is this accurate? 

Thanks everyone


what happens if co. is under bankruptcy proceedings and is reorganizing by selling.

just learn the point that “Cash is removed” and that is all that is relevant.

do not go too deep into it. none of us is a merger’s and acquisitions specialist. nor are we in any shape to say anything else. book says so, it is so.

CP

CPK (or anyone else), 

The math I get and the analogies (cash rebate) are nice, but can you help clarify.

Say Debt + Equity = $1,000 which includes the value of the company’s cash of $100…so EV = $900 which is the value of the Company’s total operations.

If i wanted to buy the company, would I pay $1,000 or the EV of $900 ??  

If you pay $900 doesn’t that mean you effectively double-count the cash bc it’s reflected in your purchase price and you still have access now to the company’s $100, so you effectively pay $800 in that scenario.  I would think you only pay $900 if you plan to let the seller keep the cash on their way out.

or

Do you pay $1,000 and once you own and possess the cash, what you’ve effectively paid is $900 ?  

The second seems more realistic..that is, you don’t pay the EV.  You pay $1,000 and essentially net the cash after the fact.  You’d be a dumb seller if you sell for $900 and let the buyer also keep the cash.

So there’s really two ways of doing the same thing:

a.) you pay $1000 and keep the cash, effectively paying $900; or

b.) you pay the EV of $900 but let the seller take the cash


Disagree.   EV = Debt + equity - cash.   

EV is a proxy for the operating asset value of the firm…how can it be total asset value if you exclude cash (an asset)?

Cash is not a cherry on the cake…unless you’re dealing with a misinformed seller.  Would you sell your equity stake in a company without the benefit of extra cash on the balance sheet.

EV is the the purchase price net of cash.  You can either pay the EV and let the seller take the cash or pay the MVIC (Debt + equity) and you assume the cash on day 1 - either way, same net answer.

You think Apple’s humungous cash pile is not reflected in their stock price ??   Apple would not sell the company without compensation for the value of its excess cash…it’s no free cherry.  Equity reflects cash.

I’m not at odds over your explanation…I just think the text is somewhat unclear.  

They suggest that EV is the theoretical take-out price, which it is, but that number is net of cash.  They explain that as a buyer you assume full right and value of the cash upon acquisition, and therefore it effectively lowers your purchase price.  That’s fine.  But to me it makes it sound like you pay EV (which is already net of cash) and then walk-in on day one and still assume the value of the cash.  If you pay EV, then that would have to imply that the seller walks out with the cash, otherwise the buyer is getting the benefit twice, once in the purchase price and once after they take control.

It’s really a net cash take-out price.

EV is not meant to be used as a proxy for how much a buyer is ‘willing to pay’ the seller but rather to gauge relative cheapness of ‘market value of equity’ given the firm’s level of debt and cash - so that the net cost to the buyer can be better ascertained. Let’s take a look at an example.

Firm A

MVE = 1000, MVD = 0, Cash = 1000

EV = 1000 + 0 - 1000 = 0


Firm B

MVE = 1000, MVD = 1000, Cash = 0

EV = 1000 + 1000 - 0 = 2000

If Firm A is bought at market value (note: cash is theoretically reflected in stock price for publicly traded firms), the buyer pays 1000 to its owners, inherits 0 in debt and has 1000 in cash on hand. Likewise, for Firm B the buyer pays 1000 to its owners, inherits 1000 in debt and has 0 in cash on hand.

Conclusion:

Firm A represents a better buy even though the amount of payout to the owners of each firm is exactly the same. Our assumption is that any differences in non cash operations between the two firms are negligible and are already priced into the stock price. This is all in theory.

In reality however, we know that market anomalies do occur. A firm is usually bought for the non cash operations of an ongoing business. Any excess cash on the books that remains after the purchase is an added incentive for the buyer. If the buyer believes a firm has strong prospects a premium over the stock can be offered taking away some of that cushion of excess cash (and thus, effectively being able to offer up to 2000 with no immediate consequences). Similarly, it may take a while for the market to realize that a heavily indebted firm with no cash reserves deserves to be selling at a discount to the current market price (and thus, being able to offer down to zero with no immediate consequences).

Trekker,

In your example, you pay $1,000 for Firm A which has $1,000 in assets and $1,000 for Firm B which has $2,000 in assets.  How can you conclude that Firm A is the better buy?  It seems Firm B is the better buy?

2000 of  that co. has 1000 in Debt - which you would need to service after taking the firm over.

(and this would be from your pocket).

CP

Like the example, but you’re last paragraph lossed me.

Earlier you mentioned that cash is typically reflected in the stock price…I agree, in theory it should.  But according to scenario A, wouldn’t that suggest that Company A is essentially only worth it’s (excess) cash since its MVE = $1000, so on-going operations are effectively worth $0, no?

Paying $2,000 for Firm A would suggest that you think there are sufficient prospects to support a 100% return over the cash value…seems steep.   Assuming there are decent prospects, I’d probably pay 1-for-1 for the cash (not sure why a seller would do less) and maybe a slight premium over that, but not much more..no?

By non-cash operations, are you referring to EV?

Imagine that you could buy all a firm’s stock for its present market cap without running up the price. Then the enterprise value would be the amount of cash on hand plus the amount of additional debt you need to take on in order to acquire the entire firm. Any cash on the balance sheet net is net cash that you don’t have to come up with or borrow with because it will be yours as soon as you acquire the firm — you’ve already paid for it. Just imagine that you will use any extra cash you acquire with the firm to immediately pay down debt, (or buy back bonds on the open market, as the case may be.)

BMiller12 wrote:

Like the example, but you’re last paragraph lossed me.

Earlier you mentioned that cash is typically reflected in the stock price…I agree, in theory it should.  But according to scenario A, wouldn’t that suggest that Company A is essentially only worth it’s (excess) cash since its MVE = $1000, so on-going operations are effectively worth $0, no?

That’s not entirely correct. The worth of Company A (or any company for that matter) is heavily dependent on its on-going operations - this is the main source of production of the excess cash we see on the balance sheet. For simplicity, let’s assume the MVE is equal to the intrinsic value of its on-going operation at the time of the transaction. If we were the buyer we’d have then paid 1000 to the seller and received an on-going business worth 1000 - an equal exchange. We haven’t gained or lost anything at this point. However, when we receive 1000 in cash as part of the deal we realize this is an added incentive - as this can be used to either plough capital back into the business (i.e. for OpEx, CapEx or acquisitions), pay them out as dividends (this also shrinks equity), or leave them intact for rainy day. 

What this boils down to is the effective cheapness of equity if we were the buyers of Company A. And that is represented by EV of 0 (value below MVE). The question of why would a seller do such a dumb thing is irrelevant as the market forces determine the potential risk and reward of any transaction. For example, if the sellers were to pay themselves dividends exhausting all excess cash before the transaction, the interest from buyers may not have been so forth coming (as EV would go up to 1000).  It’s rare to see negative enterprise values in the market - but they do exist.


BMiller12 wrote:

Paying $2,000 for Firm A would suggest that you think there are sufficient prospects to support a 100% return over the cash value…seems steep.   Assuming there are decent prospects, I’d probably pay 1-for-1 for the cash (not sure why a seller would do less) and maybe a slight premium over that, but not much more..no?

I’m not quite sure that I follow your math. The payment of 2000 to the seller leaves us with net cost of 1000 (since we receive 1000 excess cash as part of the deal). The difference in paying 1000 extra in premium is that either we need to raise the capital ourselves or use the available excess cash to pay the seller. For simplicity, let’s assume we utilize the cash on the balance sheet. And if this is a great business then paying a premium could still fare well, i.e. if the firm is returning substantial return on capital, say 20%, it would take us about 3.8 yrs to double our original 1000 investment if all of the earnings are reinvested.


BMiller12 wrote:

By non-cash operations, are you referring to EV?

Non cash operations refer to invested capital. Theoretically, EV should also not include assets that do not contribute towards on-going operations - so no, non cash operations should not imply EV. 

Can we summarize and safely say that:

- EV is the theoretical price needed/paid to acquire full control of a company and its assets.  The price reflects the amount needed to acquire all oustanding stock and repay all debts.  It is net of cash and any other nonoperating assets.  Therefore, it is essentially the operating value of a company.

- In reality, when you “buy” a company, you buy equity.  That equity should theoretically reflect the value of any (extra) cash and nonoperating assets/liabilities.   Purchasing equity gives the buyer full control of the company’s operations and partial ownership of its assets, assuming the company is partially financed with debt.   As a seller you’d be silly not to ask for/incorporate the value of any excess cash in the purchase (stock) price.  Needless to say, that aspect is negotiable.  A buyer can include the value of the cash in the purchase price and the cash component is left in the company after the seller leaves   or     the buyer can exclude the cash (lower price) but the seller will likely take the cash with him on their way out   — either way, the same price has been effectively paid.

sound good?

Yes you are correct.

In short, you effectively buy a company when you buy the equity of the target company. So, target’s company debt and cash both are part of the parent company once you buyout the target company. Since debt is an future outflow and cash is an ready liquidity in your hands we add debt and subtract cash in calculating the total amount of Enterprise Value. . This is the reason why we call it as a theotrical buy value of a company is because we dont take into account the net fair value of each balance sheet item.


Rohit Maggon