Enterprise Value: Why You Add and Subtract Items

In this Enterprise Value lesson we take a look at the rules of thumb to figure out what should be added or subtracted when you calculate it.
By http://breakingintowallstreet.com/ "Financial Modeling Training And Career Resources For Aspiring Investment Bankers"
This also covers a short case study based on Vivendi (a leading media/telecom conglomerate based in France),

Everyone knows the definition of Enterprise Value: Take Equity Value, add Debt and Preferred Stock (and others), and subtract Cash...

But WHY do you do any of that?

Enterprise Value represents the value of the company's CORE BUSINESS OPERATIONS to ALL THE INVESTORS in the company - equity, debt, preferred stock, etc.

So focus on OPERATIONAL ITEMS and ALL INVESTORS when thinking about what to include... and what to exclude!

Table of Contents:

1:19 What Enterprise Value Means

2:10 The 3 Key Rules of Thumb

5:15 Walk-Through of Vivendi's Assets and What to Subtract

11:08 How to Determine the Proper Treatment for Certain Assets

12:33 Excel Calculations for Assets Subtracted

13:30 Walk-Through of Vivendi's Liabilities & Equity and What to Add

15:14 How to Determine the Proper Treatment for Certain Liabilities

17:04 Excel Calculations for Liabilities Added

18:57 The Equity Section and Noncontrolling Interests

19:45 Recap and Summary

The Three Rules of Thumb:

1. Is this item a *long-term funding source* for the company?

In other words, will the funds we raise from this item help fund our business for years to come?

If so, you should ADD this item when calculating
Enterprise Value!

Examples: Debt, Preferred Stock, Noncontrolling Interests
(Minority Interests), Capital Leases, Unfunded Pension Obligations, Restructuring/Environmental Liabilities...

2. Will this item cost an acquirer of the company something extra when they go to buy it?

And is it NOT something that will be repaid out of the company's
normal operating cash flows (e.g., Accounts Payable)?

If so, ADD it when calculating Enterprise Value!

Examples: Debt, Preferred Stock.

3. Is this item NOT an operating asset?

In other words, could the company continue to operate even WITHOUT this particular asset and be fine?

If so, SUBTRACT it when calculating Enterprise Value!

(These items often "save acquirers money" when buying the
company.)

Examples: Cash, Liquid Investments, Net Operating Losses, Assets
from Discontinued Operations or Assets Held for Sale...

How Does Each Item In Our Analysis Satisfy This Criteria?

ITEMS THAT YOU SUBTRACT:

Cash - Non-operating asset, the company doesn't "need" it to run
its business beyond a certain low, minimum level.

Liquid Investments - Also non-operating, the company has no need
to invest in the stock market if it sells normal products/services.

Equity Investments - Non-operating, not recorded in this
company's revenue/expenses, doesn't "need" it to run the business.

Other Non-Core Assets - Typically items that will be sold off or
discontinued soon, so they're the very definition of "non-operating."

NOLs - Also non-operating since long-term tax savings from these
are not required to run the business.

ITEMS THAT YOU ADD:

Debt - Long-term funding source, and an acquirer has to repay it.

Preferred Stock - Long-term funding source, and an acquirer
has to repay it.

Noncontrolling Interests - Long-term funding source, but this
one's mostly for *comparability*... the company has recorded 100% of revenue and expenses from this company, so we want to capture 100% of its value as well (see our dedicated lesson on this one).

Unfunded Pension Obligations - They're a long-term funding source!

"Work for us now, we'll pay you a bit less, but we'll take care
of you when you retire! Really!"

To the company, very much like super-long-term debt.... but owed to employees, not outside investors.

Plus, an acquirer has to pay for these somehow...

Capital Leases - Also a long-term funding source, sort of like
debt used to fund PP&E... these leases are used to fund operations and must be repaid.

Restructuring & Legal Liabilities - Increases the cost to an
acquirer, and they are also "long-term funding" of a sort - "Instead of
paying for these expenses right now, we'll take care of them far into
the future and reflect that liability."

The Bottom-Line

The Enterprise Value calculation is always somewhat subjective, and you'll see it done different ways.

Everyone agrees on certain items (Cash, Debt, Preferred Stock), but the treatment of others varies by group, firm, industry, etc.

As long as you can justify and explain how you calculated it, you'll be fine - even if someone else wants to change it later.

To do that, keep in mind the 3 key rules of thumb above.

Further Resources
http://youtube-breakingintowallstreet-com.s3.amazonaws.com/106-07-VIV-Equity-Value-Enterprise-Value.xlsx

http://youtube-breakingintowallstreet-com.s3.amazonaws.com/106-07-VIV-Annual-Financial-Statements-Notes.pdf

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