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).
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?
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?
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.)
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.
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.
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.
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.
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.