The biggest challenge some people have is differentiating between business enterprise value and total company value. Really simple example... imagine a barbershop business that made $50,000 per year in profit and was valued at $100,000 (not a real valuation but bear with me). Imagine now that the barbershop business was owned by an Ontario corporation. Now let's pretend that this Ontario Corporation also had $300,000 in its bank account. This cash is not used or needed by the barbershop business - it is a redundant asset. The value of the barbershop business is still only $100,000; however, the total value of the Ontario corporation would be $400,000 ($100,000 for the barbershop business value + $300,000 in redundant cash it has in its account).
Looking at the Graphic below, it illustrates the components of value that are included in Total Company Value, the business Enterprise Value and the Equity Value of a company.
I will attempt to explain, at a high level, the various components of value in the graphic above.
Enterprise value can be defined as the total value of a business including both its interest-bearing debt AND its equity components, excluding the value of any redundant assets.
Using a mathematical equation to illustrate, a business's enterprise value can be expressed as follows:
Enterprise value is a useful valuation metric for a number of reasons including:
- Enterprise value is a “pure” measure of a business’s value since it is an unlevered measure of value and it measures the value of the entire enterprise, regardless of how it is financed. The amount of financial leverage (debt) can vary across businesses and make comparisons between businesses difficult but this issue is resolved by determining enterprise value.
- It removes the impact of financial leverage
- It excludes the impact of redundant assets which can also make comparisons difficult.
- Is a widely used and accepted measure of business value among professional business valuators.
As stated above, the enterprise value of a business does not include the value of any non-essential business assets (redundant assets). Redundant assets, if there are any, are generally added (at fair market value) to the enterprise value of a business to determine the total company value.
Redundant assets are not required by a business to generate the earnings from operations (they may include items such as excess cash on hand, vacant land that is unused, etc). A prudent seller would either extract the fair market value of the redundant assets or require compensation for them from a purchaser.
Equity Value of a Company
The general formula to determine the equity value of a company would be:
This formula would be used to determine the en bloc (100% value) of a company’s shares.
Minority shareholding interests in a company may require discounting from their pro rata value due to potential disadvantages that a minority shareholder may experience such as a lack of control, decreased marketability and other factors. However, for clarity, the value of a minority shareholding interest in a company does not necessarily require discounting from pro rate en bloc value. This issue is case specific and requires analysis and professional judgement.
Tangible Asset Backing
Tangible asset backing (“TAB”) refers to the tangible operating assets of a business plus its net working capital.
Determining the tangible asset backing of a business is important in order to understand the components of total business value, i.e. the amount of business value that is comprised of goodwill, other intangible assets, and the amount that is comprised of tangible assets – as illustrated in the above Graphic. It must be noted that not all going concern businesses possess economic goodwill or other intangible assets.
Goodwill refers to the amount of value that is over and above a business's Tangible Asset Backing plus any identifiable intangible assets (such as trademarks, patents, etc.). Again, a business may or may not have goodwill associated with it.
Steve Skrlac, MBA, CFA, CBV
Keystone Business Valuations