Enterprise Value, Company Value and Equity Value Explained

The Three Values at a Glance

Valuation is an art rather than an exact science. Two analysts working from the same financial statements will reach different answers, because the forecasts, the discount rate and the treatment of individual assets all rest on judgement. What follows sets out the accepted practice behind each of the three measures, and where each part of a business belongs in the model.

The starting point is the structure of the statement of financial position. A business is a collection of assets, funded partly by equity and partly by debt — in practice, almost always a combination of the two. A valuation restates both halves of that picture: what the assets are actually worth today, and how much of that value the lenders have a prior claim to. The three measures are three points along that same calculation.

• Enterprise value — the operating business on its own: the present value of the cash flows generated by operational assets, discounted at the weighted average cost of capital (WACC). It belongs to everyone who has funded the operations, lenders included.
• Company value — enterprise value plus every non-operational asset, each valued separately at market value. This is the value of everything the entity owns.
• Equity value — what is left for ordinary shareholders once debt providers and preference shareholders have been settled.

For anyone buying or selling shares, equity value is the figure that matters, and the other two exist largely as the route to reaching it reliably. A business may be worth 100 million, but if 90 million of that is funded by debt, the ordinary shareholders own only 10 million. Enterprise value is calculated first because it isolates the operating business, which can then be valued on its own risk profile without surplus assets or financing decisions distorting the result.

Reaching Equity Value

Private and owner-managed entities are frequently funded partly by loans advanced by their own shareholders rather than by share capital alone. Those loans are a claim of the same people who own the shares, so they sit inside equity value rather than being deducted as third-party debt — but they rank ahead of any distribution on the shares. Where the shares themselves are being priced, equity value is therefore split between the shareholder loan accounts and the ordinary share capital, and only the latter is divided by the number of shares in issue.

Enterprise Value

Enterprise value is the value generated by operational assets alone. It is the figure a buyer is paying for when acquiring a business as a going concern, before considering how that business is financed and before considering surplus assets that happen to sit inside the same legal entity.

The standard calculation is a discounted cash flow:

1. Forecast free cash flow to the firm (FCFF) over a window period, typically until earnings reach a steady state.
2. Calculate a terminal value at the end of that window.
3. Discount both at WACC.

FCFF is the cash available to all providers of capital — debt and equity — after the business has funded its own working capital and capital expenditure. It is struck before financing cash flows, which is what makes WACC the appropriate discount rate.

The method suits a majority or controlling interest, because a controlling shareholder can determine how operating cash flows are used. A minority holder cannot, so dividend-based methods such as the Gordon growth model are generally more appropriate at that level.

Company Value

Company value adds every non-operational asset back to enterprise value at its own market value to determine the value of all assets.

Non-operational assets are excluded from the operating cash flows precisely so they can be valued on their own terms. Surplus land, passive investments, a residential property held for an executive, or a software asset licensed out separately do not share the risk profile of the operating business, and applying the operating discount rate to their returns would misprice them.

Three points govern this step:

• Value each asset at market value net of tax on disposal. Capital gains tax and any recoupment of previously claimed deductions reduce the amount actually realisable, so the base cost or tax value is needed as well as the market value.
• Include surplus cash and cash equivalents where cash has been treated as non-operational.
• Do not add operational intangibles. A licence or patent required to manufacture is already inside enterprise value through the cash flows it generates. Only non-operational intangibles are added here.

Equity Value

Equity value is the portion of company value attributable to ordinary shareholders, reached by deducting the market value of debt and of preference shares.

Market value of debt. Where borrowings carry a floating market-related rate, carrying amount approximates market value and no recalculation is needed. Fixed-rate instruments are different: once market rates move, the market value of the instrument diverges from its carrying amount. The market value is calculated as the present value of the after-tax interest payments and the redemption amount, discounted at the after-tax market rate. Lease liabilities recognised under IFRS 16 form part of this deduction — see our guide to calculating the lease liability.

Market value of preference shares. A non-redeemable cumulative preference share is valued as a perpetuity: the annual dividend divided by the required rate of return. A convertible preference share is the present value of the dividend stream plus the conversion value, with the holder selecting the higher of the value of a comparable non-convertible instrument and the market value of the ordinary shares.

Valuing equity directly

Equity can also be valued without passing through enterprise value, by discounting free cash flow to equity (FCFE) at the cost of equity:

The interest and preference dividend lines are what separate FCFE from FCFF. Lenders and preference shareholders are paid inside the cash flows rather than deducted at the end, which is why the result is discounted at the cost of equity rather than at WACC, and why no further deduction for debt follows.

Non-operational items are then dealt with on one side or the other, never both. Where their income and capital movements are built into the cash flows — together with the interest and capital movements on any borrowing that funds them — the present value is total equity value. Where they are left out, the market value of the non-operational assets is added afterwards, net of the borrowings financing them. Both routes reach the same answer on consistent assumptions; the enterprise value route is generally clearer, because financing effects are isolated in one visible reconciliation instead of being spread through the cash flows.

Operational vs Non-Operational

Classification drives the entire valuation, and the same item can sit on either side depending on the facts.

A borrowing raised specifically to finance a non-operational asset is itself non-operational. It is excluded from WACC, its interest is added back after tax in both cash flow models, and it is valued separately alongside the asset it funds.

Building the Free Cash Flows

FCFF can be built from profit before tax or from EBITDA or operating profit. Starting from EBITDA is more direct, because depreciation, amortisation and finance costs have not yet been included, and therefore does not need elimination.

Three lines carry most of the risk of error.

Tax paid is a cash figure, not the charge in profit or loss. It is calculated as opening deferred tax plus opening current tax plus the tax expense, less closing deferred tax and closing current tax.

Capital expenditure is taken gross of depreciation — closing carrying amount plus the period's depreciation, less opening carrying amount — and covers operational intangibles such as an operating licence alongside property, plant and equipment. Where the forecast assumes growth, separating maintenance from expansion capital expenditure is worthwhile, since only the maintenance element continues into the terminal value.

Working capital movements are presented separately for inventory, receivables and payables. An increase in inventory or receivables is an outflow; an increase in payables is an inflow. Prepaid expenses are deducted and accrued expenses added back.

Finance cost is excluded for two distinct reasons, and it is worth knowing which applies: either

• the borrowing is non-operational and is valued separately, or
• it is operational and its cost is already inside WACC.

Where an operational borrowing has been left out of WACC, the interest and the capital movements must both appear in the cash flows instead, otherwise that financing is never accounted for at all.

Discount Rates and Terminal Value

WACC is the weighted average of the cost of equity and the after-tax cost of debt, weighted by the market values of each. The cost of equity is often derived from the capital asset pricing model, or from a dividend-based estimate where a reliable market price and dividend stream exist.

Where the entity's own cost of capital is unavailable, a comparable company's rate can be used and adjusted for differences in listing status, size, gearing, liquidity, regulation, diversification and expected growth. Each adjustment should be reasoned rather than applied as a single blanket premium.

Terminal value is calculated from the final year of the window, after stripping out once-off items such as an unusual capital expenditure in that year:

The window should extend to the point at which earnings stabilise. Ending it while the business is still scaling pushes an unreasonable amount of value into a perpetuity formula built on an assumption of steady growth.

Work in nominal terms throughout. Where forecasts are expressed in real terms, convert them to nominal using the expected inflation rate, or convert the discount rate to a real rate. Mixing the two overstates value, and the distortion compounds through the terminal value.

Reaching the Same Values with Multiples

A multiples valuation reaches the same three measures by applying a comparable entity's multiple to a maintainable value driver. The governing rule is internal consistency: the numerator and the denominator must relate to the same claim.

An enterprise value multiple produces enterprise value, so the remaining steps still apply: non-operational assets added, debt and preference shares deducted. Non-operational income must be excluded from EBIT or EBITDA before the multiple is applied, otherwise the related asset is counted twice. Headline earnings is generally the strongest equity driver because it already excludes remeasurements of a capital nature. Where the entity reports management-defined performance measures, their reconciliations are a useful starting point for identifying non-recurring items.

Proxy multiples rarely reflect the target's risk profile without adjustment. Adjust downwards for limited marketability, reliance on a small number of clients, dependence on key management or a short trading history; adjust upwards for a control premium, secured long-term contracts or stronger growth prospects. Forward-looking multiples are preferred to historical ones, and a range of multiples is more defensible than a single figure.

Net asset value sits outside this framework. It is appropriate where an entity is being wound up and assets will be realised individually. For a going concern it serves as a floor, since a business able to generate future cash flows should be worth more than the sum of its assets.

Practical Example

An unlisted manufacturer is being valued for a controlling stake. WACC is 14%, long-term growth after the window is 5.5%, and free cash flow to the firm has been forecast over four years.

The entity also holds surplus land with a market value of 60,000 and a base cost of 25,000, and surplus cash of 18,000. At an effective capital gains tax rate of 21.6%, the land realises 60,000 − (35,000 × 21.6%) = 52,440. Interest-bearing debt has a market value of 120,000, lease liabilities stand at 25,000, and preference shares have a market value of 30,000. Shareholders have advanced loans of 40,000.

Across 200,000 ordinary shares in issue, this is 1.62 per share. Note the scale of the terminal value: it is 74% of enterprise value, which is normal for a four-year window but makes the growth rate and the final year's cash flow the two assumptions most worth testing.

Errors That Distort the Result

Charging financial risk twice. Deducting interest within FCFF while also discounting at WACC understates enterprise value. The same applies in reverse: omitting an operational borrowing from WACC without showing its interest and capital movements in the cash flows leaves that financing unpriced.

Counting non-operational items twice. Rental income cannot remain in the operating cash flows while the property that generates it is added as a non-operational asset. The income is removed after tax, and the asset is valued on its own.

Deducting dividends from earnings. Ordinary dividends are an appropriation of capital, not an expense, and should never reduce the earnings base. Dividends on tax on distributions, where applicable, are a cash outflow and do belong in the cash flows.

Using EBITDA as an equity driver. EBITDA is struck before interest, tax and depreciation, none of which are available to ordinary shareholders. For a capital-intensive business, ignoring depreciation overstates what the owners can actually extract.

Changing capital structure mid-forecast. Where gearing shifts materially during the window, a single WACC no longer applies throughout. This typically requires two discount rate assumptions, with the change most often affecting only the terminal value.

Valuing a minority stake on control assumptions. A discounted cash flow of operating cash flows assumes the holder can direct those cash flows. A minority shareholder cannot, which is why dividend-based methods and a marketability adjustment are more appropriate at that level.

Conclusion

Enterprise value, company value and equity value are one calculation viewed at three points. Value the operating business at WACC, add what sits outside it at market value net of tax, then deduct the claims that rank ahead of ordinary shareholders. The methods used at each step matter less than consistency between them: the discount rate must match the cash flows, the multiple must match its driver, and every asset must appear on exactly one side of the split between operational and non-operational.

For clarification, guidance, or feedback on our article, please reach out to us at insight@leash.co.za.