The Lex column in the FT recently reviewed the market capitalisation of Tesla and Fiat. Tesla is bigger at $17bn Vs. Fiat at $10bn. Now some of you may find that bizarre. Fiat sells 5m cars a year and Tesla sells 20,000 (and being a niche brand will never sell 5m).
The column then goes on to to compare the Enterprise Value of both companies, defined as the market capitalisation plus debt. In this case Fiat coms out on top with an Enterprise Value of $27bn: $10bn (market cap) plus debt of $17bn. Tesla’s Enterprise Value is $21bn: $17bn market cap plus debt of $4bn.
Advocates of enterprise value believe it is a more accurate measure because if you were to buy a company you would have to write a check for the market cap (ignoring takeover premiums for a moment) plus write a check to extinguish the debt.
Let’s take a public company example to explain this further.
Let’s say the market capitalisation or the market worth on the stock market was $896m with sales of $1bn and profits after tax of $44.8m. It traded at a Price Earnings ratio of 20 thus was valued at 20 times $44.8m = $896m.
So where is debt in this equation? Let’s assume debt amounted to $400m and that the interest charge at 7% was $28m. You can see that the debt suppresses profits and thus the market capitalisation. The same company with no debt trading at the same PE would be worth $1.288bn.
Thus you can see how enterprise value tries to get to the real cost of buying a company by taking into account the debt in the balance sheet. In this example enterprise value would equal $896m (market cap) plus debt of $400m = $1.296bn. (close to the company value of $1.288bn with no debt.
Private Company Valuations
This debt issue is a crucial point in private company valuations. In practice if you use a post interest multiplier like a PE ratio, remember to add the amount of debt (less surplus cash if any). Alternatively use an EBITDA ratio to value a business debt free. Either way you will get to the real value of acquiring the company. That’s why in most private company acquisitions, the buyer wants to buy assets not shares thus leaving behind unwanted debt. Let’s face it in buying a house you wouldn’t expect to take on the seller’s mortgage!
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Still having a hard time with this concept of EV. Isn’t the debt already baked into the market cap when the company is valued? When someone buys the company aren’t they already buying the net assets of the company? Or are you telling me that the market cap only reflects to total assets of a company and disregard the liabilities.
Looking forward to your response. Thank you
I can understand why you are having a hard time. You are correct the market cap of a public company has debt factored in. Enterprise value is the name of a valuation method that assumes a debt free business. Practical example – I’m buying a private company’s assets and leaving debt behind. I’m therefore putting an enterprise value on the business to buy it BUT the sellers are taking care of debt. If I buy the shares then enterprise value is irrelevant.
Why is EV irrelevant if you are buying shares? Also, if you are buying shares and the company has significant debt should the interest not be added back to calculate adjusted profit for EV?
Well when buying shares you will assume the debt in the business. EV is irrelevant in the sense that it is an academic value. EV is the value of a business without debt. If prior to buying the shares the debt is paid off then sure EV becomes relevant. It’s probably safer to use the term debt-free basis when describing EV.