How Extra Cash Impacts Enterprise Value
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- Опубліковано 30 чер 2024
- This video will teach you how to answer a common interview question: what happens to a company’s Enterprise Value if its cash balance increases?
You’ll learn why Enterprise Value stays the same, as well as two different methods of understanding why this is the case.
By breakingintowallstreet.com/ "Financial Modeling Training And Career Resources For Aspiring Investment Bankers"
Table of Contents:
1:12 The Answer
2:50 The Explanation According to the Meaning of Enterprise Value
6:09 Why Cash is Implicitly Reflected in Equity Value
8:04 Real-Life Analogy Using a Home Purchase
12:15 Recap and Summary
What Happens to Enterprise Value When a Company’s Cash Balance Changes?
Question the Other Day: “If a CEO of a company picks up $100 of cash on the ground and puts it in the company’s bank account, what happens to the company’s Enterprise Value?”
Answer: Enterprise Value stays the same!
But… how is that possible? In the Enterprise Value formula, after all, you subtract Cash:
Enterprise Value = Equity Value + Debt - Cash + Non-controlling Interests + Preferred Stock + Unfunded Pensions - Other Investments… (and possibly other items)
That’s how you calculate Enterprise Value, but it’s not what it means.
Meaning: Enterprise Value represents the value of a company’s core business operations to ALL the investors in the company
Equity Value: Represents the value of everything the company has, but only to the Equity Investors.
So when you calculate Enterprise Value starting with Equity Value, you add items when they represent other investors or long-term funding sources (Debt, Preferred Stock, etc.) and you subtract items when they are not related to the company’s core business operations (e.g., “side activity” assets, cash or excess cash, investments, real estate…).
Back to $100 of Cash
So a better question to ask is the following: “Is this $100 of cash a part of the company’s CORE business operations?”
And the answer is no! Receiving this cash does nothing to make the business more or less valuable.
When this happens, the company’s Equity Value increases and its Cash balance also increases. Those two changes cancel each other out, and so Enterprise Value stays the same.
Remember that Equity Value implicitly reflects the company’s cash balance already - it would make no sense if, for example, the cash balance were $500 and the company’s Equity Value were less than $500. It should always be greater than or equal to the cash balance.
Otherwise, you could buy one share of the company and effectively get “free money,” since its cash per share would exceed its price per share.
So whenever “free money” comes into the company, as it does here, its Equity Value should increase.
Another Way to Think About This Topic
Consider the “home buying” analogy often used to describe
Enterprise Value: a $500K house is worth $500K regardless of the mortgage / down payment (or debt / equity) split.
If you pay $100K and take out a $400K mortgage, the house is worth $500K. And it’s worth the same if you pay $250K and take out a $250K mortgage.
The house’s “Enterprise Value” would increase if you and the owner found an extra, hidden room or figured out the house had more space than you initially thought. That extra space increases the house’s intrinsic value because buyers are now willing to pay more for the house.
But if you find something like gardening tools or random supplies in the basement, those are NOT core to the home’s value and won’t affect anything.
The owner might charge you more upfront to buy the home if those supplies come with it, but you’ll turn around and sell those supplies for cash right after you buy it… so you still pay the same net price for the house.
And that’s what it’s like when the CEO picks up $100 of cash on the ground: yes, the company has more money now, but that extra cash does NOT mean its Enterprise Value is higher.
The Moral of the Story
When you get a question like “What happens to Enterprise Value when X or Y changes?” in an interview, instead of thinking about the formula for Enterprise Value, consider whether or not the change relates to the company’s core business operations.
In other words, could it potentially affect the company’s revenue or EBITDA?
With Cash, Debt, Preferred Stock, Unfunded Pensions, etc., the answer is “no” because they only impact interest, dividends, and other items that have no impact on revenue or EBITDA.
If this change does impact the company’s core business operations, then its Enterprise Value will change in some way.
If it does not impact core business operations, then its Enterprise Value will not change.
RESOURCES:
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The analogy of finding an additional room vs $100 bill in the house on sale is so much clarifying. That you for this video.
Thanks, glad to hear it!
This is amazing - I am so happy to see this video, it considers all the relevant questions again and again, time after time, Thanks a lot!
Thanks for watching!
Great as always
Thanks for watching!
I was puzzled for a few second but then reverted back to accounting: increased the cash balance like that will simultaneously increase equity. Then, going back to the EV formula, the increased equity will be balanced out by the subtraction of cash. I saw it later in the video.
Александр Вальцев Yes, that is exactly correct. Increasing the cash balance should, in theory, also increase the company's Equity Value since Equity Value reflects the value of everything the company has. And then the increased Equity is balanced by the subtraction of cash in the Enterprise Value formula.
@@financialmodeling Why should we deduct non-operating assets? Let's say we have an operating asset on balance sheet, the value of which is estimated by the DCF model and also we have on the balance sheet is not an operating asset (for example, real estate). So if EV is the value of a company's core business, why should we deduct the value of non-operating asset? There is no sense. Non-operating assets have no relation with core business. We have to add them up to get the value of the whole company.
@@Dmitry-dy9yi Um, you do add non-core or non-operating assets to get the value of the entire company. That's what happens at the end of a DCF when you move from Implied Enterprise Value to Implied Equity Value. But the point is that you can only *pair* All Assets with Equity Value, and you can only *pair* Core Operating Assets with Enterprise Value. No one is arguing that non-operating assets are worthless; it's just an issue of which set of Assets you pair with which metric.
Very well explained.. However, I have a small question with regards to the calculation of Enterprise Value (EV). As was rightly stated in the video, the EV calculation typically adds 'core' or 'operating' assets and subtracts the 'non-core' assets. Therefore, when calculating the EV, would it not make more sense to subtract only the 'extra' / 'free' cash that the company would not use for its growth and not the entire cash balance that a company has on its balance sheet?
Shashank Mallya Yes, it would. The issue is that most companies don't disclose the amount of cash that's required to run their businesses, so you can't really determine the amount of "extra" cash they have. So as a simplification and way to standardize the calculation, typically you subtract the entire cash balance in the Enterprise Value calculation.
What would happen to the EV if the company takes on debt $2m and invest that cash in a project with a NPV of $3m? Thanks for your sharing, your points are well thought!
Depends on how the project is recorded on the Assets side. If it's recorded at its Book Value of $2 million, Enterprise Value increases by $2 million because Net Operating Assets go up by $2 million. If it's later revised up to $3 million, Enterprise Value increases by $3 million instead.
I was just unsure about one of the parts. I kind of understand how the market value of equity cannot be below $100 as shareholders will be paying less and receiving more. However, i don't understand how in a real life situation, if a ceo picks up $100, and puts in in the business, how does this translate to the change in the price or no. of share outstanding to account for that $100 increase?? Thanks, it was a great video.
The $100 would count as an Extraordinary Gain on the Income Statement. So, Net Income would increase by $100 (ignoring taxes), Cash would go up by $100, and the extra Net Income would flow into Equity and increase Retained Earnings by $100. It's like the company just earned free money for no particular reason.
Oh yes i understand how it increases on the financial statement, but how does the market cap (stock price x shares outstanding) increase by $100 as that is what needs to happen to offset the $100 increase in the EV formula?
Thanks!
Because the company's Cash goes up by $100. Equity Value reflects the value of All Assets but only to equity investors. If All Assets increases by $100, and it was a result of something attributable to Equity Investors, Equity Value increases by $100 (so the company's stock price will increase).
Thanks a lot for the video. I did'nt realy understood your first example, if a company has 500$ in cash that was generated out of a 400$ loan from the bank, this means that the Equity value is worth 100$ and not at least 500$, right?
The book value of Equity should be $100, yes, but the market value is different. The market value of Equity represents the value of all Assets but only to common equity investors... so if the company's only Asset is $500 in Cash, the market value of Equity should be at least that much.
Sir, i have a little doubt, let's say I am gonna purchase a company having ,equity of 2000$, debt of 1000$, equity includes 500$ of cash . So as per enterprise value method it's value would be 3000-500=2500$... doesn't it reduces the value of the firm, bcz i would get the cash for free in that case. It would be very helpful if you can clear this doubt.
I don't know what you are asking. You are effectively paying $2500 for the company in this case. The cash does not "reduce" the value of the firm, as extra cash boosts the company's Equity Value. So less Cash means you subtract less in the Enterprise Value formula, but that Equity Value is also lower.
Hey Brian,
what do you mean with "VALUE to all investors"?
I understand cashflow to all investors. The cashflow which pays the investors. (Net Income => Equity Investors ; EBITDA => Debt Investors)
What is meant by value here?
Maybe, I could understand that the equity investor owns the equity value. (Equity Value => value to equity investors)
But how can a debt investor owns a company value?
It is the same concept as Unlevered Free Cash Flow being available to all investors, but this relates to capital structure rather than cash flow. "Value" just means how much of a company's capital structure each group represents. So if it's "Value to All Investors," you have to add up each components of a company's capital structure, i.e. Equity + Debt + Preferred Stock + Others, ideally using the market value for everything.
Thank you!
But which part specifically of equity value would mathematically account for the extra $100? Would its market cap go up by $100?
harino45 The market cap should go up, yes. Equity Value should already reflect the company's entire cash balance. It may not immediately go up by $100 if the company has an extra $100 in cash, but it should, in theory, increase by that amount eventually.
Mergers & Inquisitions / Breaking Into Wall Street Thanks for the reply. But if market cap doesn't go up by $100 immediately, wouldn't that mean EV actually goes down a little because the extra $100 is fully subtracted?
harino45 Yes, potentially. But this is intended for use in response to an interview question, and doesn't necessarily reflect exactly what happens in real life the moment the company collects the extra cash.
What would happen if a company pays out dividend with cash on its hand? Would the Enterprise value remain the same as both cash balance and equity value decreases?
Yes.
minute 7, if a company has 500 cash no other assets, but 1000 debt it would make sense that the equity value would be below 500
having watched the last part: the enterprise value reflects what you have essentially paid for the company not what you should pay , so the actual value at which you buy the home increases, right?
JohnDot At minute 7 we are talking about the case where the company has no debt but $500 in cash. In that scenario, its shares could never be worth less than $500 total unless something very odd is going on.
Enterprise Value reflects the value of the core business or the core property for real estate. So it only increases if something intrinsic about one of those improves - a renovation, more space, higher profits or revenue, higher growth, etc. The point is that it should not change simply because the cash, debt, or other parts of the capital structure have changed.
Mergers & Inquisitions / Breaking Into Wall Street thank you for your quick reply, however you didnt answer the last part of my post, i get that thingy with the core value, however, is the enterprise value the price you should pay for a company or not? as far as i understood it isnt, because you buy the whole company and dont carve out only the core business
JohnDot The Enterprise Value represents the effective price you pay for a company if you "take" that company's cash for yourself afterward and also repay its debt and other debt-like liabilities. So yes, assuming you buy the entire company, the Enterprise Value represents the effective price you should pay.
Whtat happens in a theoretical case when the CEO picks up $1M of cash on the ground and the company's EV is $0.5M? Will the EV still be $0.5M?
Yes. Equity Value would increase, and so would Cash, so they would offset each other, and Enterprise Value would stay the same.