Hi guys,
My boss asked me this question today and I didn’t have the answer.
Method 1. Enterprise value = FCFF discounted with WACC
Method 2.Equity value = FCFE discounted with Cost of Equity
–> Enterprise value = Equity value + debt value
Theoretically speaking, Enterprise value calculated using both methods should yield the same result but in real life it does not. Can you you tell me why ? and in what situation will the result be the same for both methods?
If there is a changing capital structure the two would not be equal, that’s the first thing that came to my mind.
The enterprise value-debt=equity value assumes that the debt weighting in your WACC will be the debt weight forever, so if the firm is growing debt has to grow with it (and at the same rate).
^ agree about changing capital structure, becaus then you are using incorrect WACC in some periods and the FCFE will also be wrong. of course, if you have perfect foresight they will be the same
I would unlever the firm, removing all debt, discount at cost of equity.
then, relevered firm value = unlevered value + debt(1-tax)
then equity = levered firm value - debt.
“Enterprise value = Equity value + debt value”
The important thing here is to use the correct market values for each year for the beta calculation and WACC weightings. One method that is used is the so called roll-back method where you start calculating the market weighted discount rates for CoE and WACC for the terminal value year and continue to do so rolling back until the present year.
Since this implies a circularity problem (you need to know the EV/EqV for the discount rate and vice-versa) this is best done in excel.
Just try to setup a small model in excel. If you do it correct you’ll see that both methods will yield to exactly the same result.
In practice you’ll see this approach however used only by the real valuation nerds as this topic is handled normally in a more pragmatic way
Regards,
Oscar
You are right it should match using both methods, but for reasons provided by other posters it does not. Check out this guys (Pablo Fernandez at IESE) work - he shows how to reconcile a number of different valuation approaches (you will need some tricky Excel modelling and iterative calculations to do this right). I would encourage you to try it out for yourself in Excel. It is unlikely this will be applicable in real life, but you can use this method to check how far off the different methods are. That way you won’t be surprised when someone asks, why is EV different. You will also have an explanation ready.