01Two different questions
Enterprise value answers the question "what is the business worth?" regardless of how it is financed. Equity value answers "what are the shares worth?" after accounting for the claims of lenders and other parties that rank ahead of shareholders.
Earnings multiples based on EBITDA or operating profit usually produce an enterprise value, because those profit measures are calculated before interest. To reach equity value, further adjustments are needed.
02The bridge between them
The adjustments from enterprise value to equity value typically include:
- Deducting borrowings, including bank loans and finance leases
- Adding surplus cash not needed to run the business
- Deducting debt-like items, such as overdue tax, deferred consideration or certain provisions
- Adjusting for working capital that is above or below the normal level for the business
- Adding the value of assets not used in the trade, such as investment property
03Why it matters
Two businesses with identical profits can have very different equity values if one is heavily borrowed and the other holds a large cash balance. In a sale, a buyer's offer of a certain multiple of EBITDA is usually an enterprise value, and the sellers receive the equity value after the adjustments above. Misunderstanding this is a common source of disappointment late in a transaction.
In share valuations, the value of a particular holding starts from equity value, then considers how that value is shared between share classes and the rights of the holding itself.
04Defining the items
What counts as debt-like, and what level of working capital is normal, can be matters of judgement and negotiation. In transactions they are often defined in the sale agreement. In valuations, the valuer explains which items have been treated as debt and why.
This guide is general information, not advice on any particular situation. The correct approach to a valuation depends on its purpose, the basis of value and the facts.
