Chapter Two: Corporate Valuation

What Is Corporate Valuation About?

Valuation is crucial in corporate business. It is the process of determining the value of an asset or a financial
instrument (based on book value or market value or present value). It shows how much is this entity worth?

When we discuss the valuation of a company, we may be referring to any of the following:
• Enterprise Value: Valuing the company’s productive activities.
• Equity Value: Valuing the ordinary common shares of a company, whether for the purpose of buying or selling
a single share or valuing all of the equity for purposes of a corporate acquisition.
• Debt Value: Valuing the company’s debt. When debt is risky, its value depends on the value of the company
that has issued the debt.
• Other: We may want to value other securities related to the company. For example, the firm’s warrants or
options, employee stock options, etc.

Enterprise Value (EV)

The key concept in corporate valuation is enterprise value. Enterprise Value (EV) is the value of the company’s
core business operations (i.e., Net Operating Assets), but to ALL INVESTORS (Equity, Debt, Preferred, and
possibly others) in the company. By contrast, Equity Value (also known as the Market Capitalization or “Market
Cap”) is the value of EVERYTHING the company has (i.e., Net Assets), but only to the EQUITY INVESTORS
(common shareholders). Enterprise Value is important because it is not affected by a company’s capital structure
only by its core-business operations. Enterprise value would change only if the company’s net operating asset
changed. Enterprise Value is a measure of company’s total value, often used as a more comprehensive
alternative to equity market capitalization. Enterprise value gives an accurate calculation of the overall current
value of a business, similar to a balance sheet. As its name implies, enterprise value (EV) is the total value of a
company, defined in terms of its financing (debt and equity) right side of balance sheet. On other hand, the left-
hand side of the resulting balance sheet is the firm’s enterprise value, defined as the value of the firm’s
operational (productive) asset. Enterprise Value (EV) is a measure of a company's total value, including its debt,
equity, and other liabilities.

In this chapter we refer to the market value of operating assets (industrial and commercial) as ‘‘enterprise
value’’, which is the sum of the market value of equity (i.e., the company’s market capitalization if it is
publicly traded) and the market value of net debt. Enterprise value and firm value are synonyms.

The Four Approaches to Computing Enterprise Value:

a) The accounting (Book) approach to EV moves items on the balance sheet so that all operating items are on
the left-hand side of the balance sheet and all financial items are on the right-hand side. Although most
academics sneer at this approach, the balance sheet of a company is a useful starting framework for the
valuation process. In general, the book value approach values the firm’s enterprise value using its balance sheet
numbers, appropriately rearranged.

b) The efficient markets approach to EV revalues—to the extent possible— items on the accounting EV balance
sheet at market values. An obvious revaluation is to replace the firm’s book value of equity with the market
value of the equity. To the extent that we know the market value of other firm liabilities debt, pension
obligations, etc. This market value will also replace the book values. In general, the efficient markets approach
substitutes, where possible, market values for financial assets and liabilities instead of their book values, and
then makes appropriate adjustments to the valuation of the firm’s real assets (Non-current/Long-term/PPE).
Both approaches possess the same procedure to determine enterprise value.

c) The income (discounted cash flow) approach values the EV as the present value of the firm’s future
anticipated free cash flows (FCFs) discounted at the weighted average cost of capital (WACC). The FCFs can best
be thought of as the cash flows produced/generated by the firm’s productive assets (core business activities) —
its working capital, fixed assets, intangible assets. When used as the discount rate for a firm’s anticipated free
cash flows (FCFs), the WACC gives the enterprise value of the firm. The discounted cash flow (DCF) has two
approaches/methods, a consolidated statement of cash flows and a pro-forma model for the firm’s financial
statements. Implementation of the two DCF approaches will be discussed separately in chapter4.

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 Summary of Enterprise Value (Under the Three Approaches)

DCF Approach
Book Approach Efficient Market Approach

Or simply,

On the left side---> EV = NWC + PPE + IA (Book Value Approach)

For modeling purpose, we focus on a narrower definition of working capital called operating working capital.
Operating working capital is also defined as current assets minus current liabilities. However, we do not include
cash and cash equivalents and/or marketable securities as part of current assets and we do not include interest
bearing short-term liabilities (I.e., short term debt and current portion of LTD) as part of current liabilities.
Thus, networking capital (NWC) is computed by subtracting operational current liabilities from operational
current assets. Operating current assets includes account receivables, inventory, prepaid expenses and other
current assets; while, operating current liabilities contains account payable, tax payable, accrued expenses and
other current liabilities.

Net Operating Asset Value (NOAV): This method of calculating EV involves determining the net operating
asset value of the company (the total value of its operating assets minus its operating liabilities).

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 On the right side---> EV = MC + (D – C) (Market Value Approach)
Equity value, simply it is outstanding common stock at market value, this line item is also known as "market
capitalization" (MC). On the other hand, net debt at market value is total financial debt at market value (D)
minus cash, and cash equivalents and/or marketable securities) (C). (Here debt refers to interest bearing
liabilities, both long-term and short-term debts). Preferred stock at market value (PS), minority interest at
market value (MI) and other liabilities like unfunded pension at market value.

Market Capitalization + Debt – Cash: This is the most commonly used method to calculate EV, where you
add the company's market capitalization (the total value of its outstanding shares) to its debt and subtract
any cash and cash equivalents.

Here, all cash, cash equivalents and marketable securities (excess/surplus liquid assets) are subtracted because
it not considered as an operating asset; it is not an asset that will be generating future income for the business
(arguably). And so, true value of a company to an investor is the value of just those assets that will continue to
produce profit and growth in the future (i.e., operating/productive assets). For that reason, net debt assumes
that cash and marketable securities are “surplus” or “redundant” and not used for day-to-day operations of
working capital or fixed asset investments (CAPEX) but, can be used to pay down parts of debt and dividends.
However, the implementation of this particular piece of theory is largely a judgment call—we may not want to
attribute all cash to the possibility of paying off debt. Therefore, practically it is important to assess whether
excess liquid assets truly are “redundant” (out of work) or readily disposable.

Synonym terms: - “Cash and cash equivalents” or “cash and temporary marketable securities.” “Temporary
marketable securities are sometimes also called short-term investments”. In some case “Cash and cash
equivalents and “marketable securities” are recorded separately. All they are listed at their fair value (current
market value).

1. Book Values Approach to Value a Company: Firm’s Accounting Enterprise Value

In this section we show how accounting statements can help us define the concept of enterprise value (EV). As a
starting point, consider the balance sheet for XYZ Corp.

We rewrite this balance sheet:

• We separate the operational versus financial items in short-term assets and short-term liabilities.
• Operational current asset (Account receivables, inventory and other current asset)
• We move the operational current liability (Account payable, tax payable and other current liabilities) to the left
side of the balance sheet to determine net working capital.
• We move all the financial debt (short-term debt or short-term borrowing, current portion of long-term debt, and
long-term debt) into one debt item.
• We move liquid asset (cash, and cash equivalents, and/or marketable securities or short-term investment) from left
side to the right side of balance sheet to assume the payment of financial debt.

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Gross debt is all interest-bearing debt (both current and long term). Whereas, net debt is all interest-bearing
debt (often referred to as gross debt less cash, cash equivalents and marketable securities). To be more specific
“Debt lenders and other obligations” can include short-term debts, long term debts, current portion of long-
term debts, capital lease obligations, preferred securities, non-controlling interests, and other non-operating
liabilities (e.g. unallocated pension funds).
Remember that, even though preferred stock is reported in the equity section of the balance sheet, it does have
debt component and are reported separately as these items represent share of other shareholders. Therefore,
EV treats preferred shares more likely debt for this calculation since they often required a fixed dividend rate.
It sometimes also called hybrid security.
On other hand, equity value shows only the values of ordinary common shareholders (equity shareholders);
because shares of common stock are the fundamental ownership units of the corporation and the common
shareholders are considered as the founder and true (real) owners of the corporation.
Thus, to calculate equity value from enterprise value (EV), subtracts debt and debt equivalents, non-controlling
interest and preferred stock, and adds cash and cash equivalents and/or marketable securities. Or simply, it is
common stock price multiplied by number of common stocks outstanding (“market cap”).
Generally, equity value is concerned with what is available to equity shareholder’. Debt and debt equivalents,
non-controlling interest and preferred stock are subtracted as these items represent the share of other
shareholders.

In the next step we subtract excess liquid assets (cash and cash equivalents and/or marketable securities, if any)
from financial debts, to get the firm’s net financial debt. Notice that we netted out liquid assets from the
financial debts of the company. The assumption is that these assets are not needed for the core business
activities of XYZ. When we finish this step, we have all of the firm’s productive assets on the left side of the
balance sheet and all of its financing on the right side. The left-hand side of the resulting balance sheet is the
firm’s enterprise value, defined as the value of the firm’s operational asset. These are the assets that provide
the cash flows for the firm’s actual business activities. Thus, the book value of XYZ’s enterprise value is $5,750.

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 Left Side Enterprise Value (EV) Balance Sheet under Accounting Approach

2. The Efficient Markets Approach to Corporate Valuation

The XYZ example above assumes that the book value is a correct valuation of the company. But a simple
calculation shows how problematic this is: At the end of 2011 XYZ had 524 shares outstanding, and the market
price per share was $18. This suggests that the XYZ’s enterprise value is $11,032—a far cry from the book value
of the enterprise value of $5,750.

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The efficient markets approach to the valuation of XYZ’s equity and financial liabilities assumes that the market
value of a company’s shares or debt is simply the market value at the time of valuation. This approach is better
than the accounting approach. It is based on the idea that the market price of a company’s stock reflects all
available information about the company, and that the stock price is the best indicator of its true value. This
approach relies on the efficient market hypothesis, which states that market prices reflect all available
information, and that it is impossible to consistently outperform the market by trading on such information.

Applying the efficient markets approach to the XYZ Enterprise Value Balance sheet gives 11,032 for the
right-hand side of the enterprise value balance sheet. This means, of course, that we have to revalue the
left-hand side of the balance sheet. One approach to bringing this enterprise value balance sheet into
balance is to assume that the net-working capital’s book value is a reasonable approximation to its market
value. We can then re-compute the market value of the firm’s operational (productive) long-term assets to
bring the balance sheet into balance by subtracting networking capital from enterprise value.

If operational net working capital (as named in this course) is positive, operational current assets are greater
than the operational current liabilities, we will potentially have more than enough funds to cover our
liabilities coming due. If operational net the working capital is negative, operational current assets are less
than the operational current liabilities, we do not have enough resources to pay our operational current
liabilities, an operational working capital deficit, which means a firm is in liquidity problem (illiquid). For
this reason, operational working capital is regarded as a measure of a company’s near-term liquidity.
On other way, operating working capital is a good measure of how much cash is coming in from the day-to-
day operations. It helps track how well a company is managing its cash generating from day-to-day
operations. In contrast working capital, because it includes cash, cash equivalents, and debts, may not give
the clearest measure of just the day-to-day operations.

Note that we could also apply the market valuation to financial debts and other components of the right-
hand side of the balance sheet—we could try to revalue the firm’s financial obligations, its pension
liabilities, and minority interest. However, it is difficult to determine the value of debts in the market.
Further, this valuation is usually not done, unless there is a convincing case that the book values for these
liabilities differ materially from their market value.

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 Right Side Enterprise Value (EV) Balance Sheet under Efficient Market Approach

Valuation Categories Shareholders’ Equity @ Book Shareholders’ Equity @ Market

(Equity value) (Market Capitalization)
= Common share outstanding at par value + = Common shares outstanding x
Equity Value Stocks options and warrants (if any) + current market share price.
additional paid in capital or capital surplus
+ retained earnings ± other comprehensive
income/loss – treasury stock or stock
repurchase

Summary

This chapter emphases on a short overview of enterprise value and equity value and various valuation methods
as applied to corporations.
Enterprise value (EV), also known as total enterprise value or firm value), entity value is a measure
reflecting the market/book value of a whole (entire) business. It is the sum of claims of all the security-
holders: debt holders, preferred shareholders, minority interest, common equity holders, and others. On
other side, equity value is the value of a company available to equity shareholders; that is, the value of
the business excluding debt lenders, minority interest holders, and other obligations.

The value of a group’s equity and debt lies in the value of its core operating assets. Since operating assets
are financed exclusively by means of shareholders’ equity and net debt, we get: Value of operating assets
= Value of net debt + Equity value

We have introduced two enterprise-value (EV) valuation methods:

a) The book value approach values the firm’s enterprise value using its balance sheet numbers, appropriately
rearranged. We will explain why subtracting cash and cash equivalents are significant. So, to arrive at
enterprise value on a book value basis, we take the shareholders’ equity and add back any potential debts and
obligations less cash and cash equivalents. On the other hand, equity value is the enterprise value plus all
cash and cash equivalents, short term investments, and less all financials debt, preferred stock and minority
interests. Preferred stock at (PS), minority interest (MI) and other liabilities are considered debt equivalents.

b) The efficient markets approach substitutes, where possible, market values for financial assets and
liabilities instead of their book values, and then makes appropriate adjustments to the valuation of the firm’s
real (long-term operational) assets. Similarly, if we add to market capitalization any potential debts and
obligations less cash and cash equivalents, we approach the enterprise value of a company on a market value
basis. On the other hand, equity value is the market value, or market capitalization, is based on the stock
price multiplied by outstanding common shares.

Enterprise value is sometimes confused with equity value. Equity value is the enterprise value remaining for
shareholders after creditors have been paid. To avoid confusion, remember that enterprise value is the sum of
equity value and net debt value.