This entry is part one in a two part series on Enterprise Value
Enterprise Value is widely used in the finance world as being the standard for total firm value. It is the market value of the whole company that includes the assets owned by all shareholders, debt and equity. The widely used formula is:
Enterprise Value (EV) = Market Value of Equity + Market Value of Debt + Minority Interest – Total Cash
The savvy finance scholar can point out two flaws in this formula; the last two terms aren’t as simple as they seem. The first issue is with minority interest and the second is with cash. Over the next two posts, we will attempt to their significance in the formula, and why their treatment in the formula isn’t perfect. Part 1 (this post) focuses on the cash component of Enterprise Value.
Why we Subtract Cash
Cash in the DCF
In a proper DCF model, the analyst would model cash as a component of current assets. As a company grows in size, it needs more and more cash to perform its operations. Therefore the contribution to the cash account each year in a growing company is a “use” of funds. Here’s the problem. If the Enterprise Value calculation measures firm value without cash, the value that the DCF approach spits out is a value that includes some level of cash necessary to operate.
In the valuation of a private firm or a public company at its fair market value (which may be different from the market value) we would calculate the MVIC by utilizing the Income, Transaction and Guideline Company Approaches and adding excess and non-operating assets.
Enterprise Value (EV)
Enterprise value is less clearly defined, and a widespread definition has not been adopted. Some calculations of EV subtract only the excess amount of cash and cash equivalents from the MVIC to arrive at enterprise value, although most definition of enterprise value subtract all the cash and cash equivalents. Why does this matter?
