Analyst Corner – Calculating A Firm’s Enterprise Value

Hello everyone, I am starting a new sub-chain of blog posts that I will put up from time to time regarding financial modeling and analyst fundamentals.  If you have a topic you’d like me to cover – assuming I know it well to speak on it – I would be happy to address it, feel free to write a comment to my post with your request.

How To Calculate A Firm’s Enterprise Value
When valuing companies, analysts and investors often must determine their most accurate calculation for the Enterprise Value (EV) of  firm.  By the simplest definition, a firm’s EV is the value of its core business activities – the a starting point foundation for arriving at M&A offers, stock price valuations, and so forth.  For companies with liquid, publicly traded debt and equity instruments, the short-hand approach to determine EV is simply to take the market value of all the firm’s equity (i.e., the number of public shares multiplied by the price per share), add to that the market value of the firm’s debt (also can taken from public exchanges if it’s publicly traded), and then subtract cash and cash equivalents (listed in the Balance Sheet).  Put another way, you take all the net assets and the debt of a firm (which is usually used for fixed asset CAPEX anyway), subtract the cash out (since cash is not a unique value to a firm, and if you bought the firm it would be without of this cash anyway), and this gives you the EV.

Simple, right?  Well not always – many firms do not have publicly traded debt and/or equity, and even when they do have one or both of those, often analysts will be looking to see if those items are mispriced in the market.  Such mispricings – aka market inefficiencies – are where the money is made and where analysts demonstrate their value.

Calculating EV By Using The Balance Sheet
The roughest way to approximate a firm’s EV is to look at its balance sheet and make some adjustments.  Specifically, there are two adjustments to make.  First, put everything on spreadsheet in front of you, assets on the left side and liabilities + equity on the right side. Then, create a new specific item on the left side and the right side – on the left side the new item, which appears above Fixed assets, is called “Net Working Capital.”  On the right side, above the first item that is non-financial long term liabilities (Pension Liabilities for example)create a new item called “Net Debt.”

Now comes the first adjustment.  Take Cash and Cash Equivalents (including Marketable Securities) away from Current Assets, and move them to the right hand side of the Balance Sheet, subtracting them from Total Debt of the firm, to arrive at the new line item “Net Debt.”

And the second adjustment.  Take Current Liabilities that do not refer to debt (aka operations related Current Liabilities such as Accounts Payable and Taxes Payable), and subtract those from the remaining Current Assets on the left hand side, to arrive at your new “Net Working Capital” line item on the left hand side of the Balance Sheet.

If the firm has no publicly traded debt or equity, this simple process will give you a rough sketch of a firm’s EV just using the Balance Sheet.  Note that all items on a firm’s balance sheet are generally different from the market value of the same items, because they reflect historic values for the most part – the values as of when they were originally entered to the balance sheet.

To account for valuation discrepancies between balance sheet values and current market values, when a firm has publicly traded equity an analyst can make a slight corrective adjustment to the process above.  He or she can replace the book value of equity on the firm’s Balance Sheet with the real market value of the firm’s publicly traded equity (taken from Yahoo Finance or Bloomberg, etc.).  This will create an imbalance between the right hand side and the left hand side of the Balance Sheet.  To correct this, the analyst can manually change the left hand item value for “Goodwill” to cover the difference, so that the left and right hand sides match again.  At the bottom of each side, the matching value is the firm’s estimated EV.

Calculating EV By Using A Firm’s Consolidated Statement Of Cash Flows
Every firm includes a consolidated statement of cash flows (CSCF) in its financial statements.  Cash flows generated by the firm over the defined period of the statement are broken into three easy to separate categories: operating cash flows, investment cash flows, and financial cash flows.

There are many formulas for calculating EV of a firm, and one applies particularly here.  EV can be defined as the sum of all expected free cash flows to the firm (FCF) discounted by its weighted average cost of capital (WACC).  I will discuss WACC in more detail in future post.  For now, the important thing is to know how to get FCF from a firm’s CSCF, and then we assume here you’ve got the WACC handy already.

To estimate a firm’s FCF based on its CSCF, the analyst does the following three general things (corresponding to the three sections of the CSCF itself).  For operating cash flows, the analyst generally leaves everything alone and keeps things as they are.  But oppositely, the analyst totally eliminates/disregards all financial cash flows.  For investment cash flows, the analyst makes a few tactical adjustments – all cash flows related to investments and the purchase and sale of financial assets are deleted.  The rest of investment cash flows – the ones related to investment in assets used to produce a firm’s business income – are left included.  The analyst adds the operational cash flow to the “adjusted” investment cash flow, and then adds in Interest After Tax (Interest expense multiplied by 1-Tax Rate) to get the FCF.  This FCF can then estimated across future years by an analyst’s estimated growth rate, while also discounted by WACC (divided by 1+WACC in year 1, etc.) to get the firm’s  EV.

Calculating EV Using A Firm’s Income Statement And Balance Sheet Together
Another formula for calculating a firm’s EV is:  EV = (EBIT)(1-Tax Rate)-(Change in Net Working Capital)-(Increase in Fixed Assets).  This can be also broken down into: EV = (EBIT)(1-Tax Rate)-(Increase in non-cash Current Assets)+(Increase in non-debt Current Liabilities)-(Increase in Fixed Assets).

With that in mind, if you have the firm’s Income Statement combined with its Balance Sheet, you can easily calculate EV using all these line items above.  Just plug and play.  The tax rate is determined by looking at the Income Statement, and dividing the firm’s Income Tax Expense line item by its Income Before Tax line item.

I hope this was helpful to someone, if you have other financial modeling/valuation topics you’d like me to cover here I am happy to try my best efforts.

Market

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