It is a common error to regard the value of a business to be the same as the value of a company. This is also referred to as the enterprise value and equity value, respectively. So, are they not the same? Let’s dig deeper!
Consider a company with different assets and liabilities. Let us categorise these according to their functions: Some are essential to operate the business and others are not essential. The essential assets and liabilities can be grouped together and regarded as the operating assets or to be more precise: The Enterprise. This enterprise can operate and function independently from all the other assets and liabilities in the company. They can even be sold separately if needed. The other assets also have value, but they can be disposed of without any interruption to the operations. The long-term debt financed the assets of the Company and could be redeemed under fair commercial terms without any influence on the operations of the Company. It is thus not regarded to be part of the Enterprise.
We need to separate the Enterprise from the rest of the assets and liabilities. Why? Because it is valued differently, recognising the ability to generate cash flows in excess of the fair market value of each individual tangible asset. This Enterprise needs to be valued as a going concern and its value is referred to as the Enterprise Value. So how is this then different from the value of the Company itself?
We need to consider the position of the shareholders if they were to decide to sell the underlying assets of the business individually and distribute all the proceeds as a final dividend. They would firstly sell the Enterprise on a going concern basis, in other words at the enterprise value.
They would then sell non-operating assets, such as property and other investments, and use all the cash proceeds to settle outstanding debt. This will leave them with cash to distribute to the shareholders.
This final distribution to the shareholders can be regarded as the equity value of the Company.
What can we conclude from this? The Enterprise value and non-operating assets, after allowing for the settlement of debt, constitute the capital of the Company, in other words its Equity Value. We need to also consider the circumstances under which such shares could be sold in the open market. If it is a majority stake, a control premium may be realised but if it is a minority stake, a minority discount could apply. How marketable are the shares? If they are not listed, a marketability discount may apply.
Let us then take the principles that we discussed and summarise them in a formula. The collective of Enterprise value and non-operating assets at fair values, after the settlement of debt, derive an equity value on a non-marketable basis. An allowance is made for the circumstances of the sale and an appropriate discount is recognised if such shares cannot be traded in a liquid market, to calculate the equity value on a marketable basis.