Calculating Enterprise Value: Corporate Financial Planning

Corporate Financial Planning
Corporate Financial Planning

Corporate Financial Planning and Calculating Enterprise Value

Calculating Enterprise Value:  A key aspect to corporate financial planning is looking beyond just driving revenue growth to ensure the Company is growing its value. There are multiple ways to value a business and they are all academically correct; however, there is one methodology, often called Enterprise Value, that is used more than others when valuing businesses, completing management buyouts, partner buyouts or raising capital.  Given its importance, here is a very brief description of enterprise value and a simple example.

The Enterprise Value Formula 

As shown below, enterprise value is basically a formula. That formula and a brief description of each component is provided below:

Enterprise Value = (EBITDA +/- Adjustments) X a Multiple + Cash – Debt

EBITDA - Stands for Earnings before Interest Taxes Depreciation and Amortization. Its intended to represent the operating income or cash flows generated by the business without influence from taxes, depreciation or interest expense which can vary from one company to the the next. EBITDA has its shortcomings but since most companies use it, we do too. EBITDA is usually taken from the prior year, last twelve months or an average of last 2, 3 or 4 years.

Adjustments – To estimate the cash flows from the business, you often have to ‘normalize’ them for things such as (1) one time gains or losses (lawsuit, sale of asset), (2) discretionary owner expenses (owners often have personal expenses in the business that need to be added back to show the profitability without them) and (3) on-going capital expenditures (or “cap-ex”) which is the average annual expenditure a business spends each year on new equipment and assets to keep the business running. On-going cap-ex needs to be deducted from EBITDA because these cash expenditures are recorded on the balance sheet not the income statement which means cap-ex expenditures are not part of the EBITDA calculation. Without this adjustment the EBITDA calculation overstates the real underlying cash flows of the company. (In a future post, we will discuss this and other adjustments in greater detail.)

Multiple – Is the multiplier you apply to cash flow to get a value for Enterprise Value before factoring in cash or debt. For most private companies (other than technology companies) with an enterprise value of $100 million or less, a pretty common multiple is “5” with a common range of 3 to 6. The reason “5” is common is because it implies the buyer will get a 20% return on their investment every year after buying it (assuming the same cash flow) and that is a reasonable return for an illiquid investment like buying a company. In reality, multiples are just transaction averages and they can very significantly from one company or industry to another. If interested, , there are databases that will provide data by SIC code.

Cash – Typically any cash left in the business gets added to the valuation. This incentives sellers to avoid draining out cash just prior the close of a sale of business.

Debt - When valuing companies based on a multiple of cash flow it is assumed that bank debt will be deducted from the purchase price, meaning the seller is expected to pay off the debt from the proceeds of the sale or if the buyer assumes the debt, it effectively raises the enterprise value of the Company.

What’s not included in the calculation

What is not included in the calculation of enterprise value is additional consideration for the sale of assets such as accounts receivable, inventory or plant and equipment, etc. It is assumed that enterprise value encompasses (and includes) the short term and long-term assets of the Company as well as the business liabilities (not including debt). There is much more to say about this topic, but the main point is buyers value companies based on the the cash flows that business generates and they (typically) don’t pay extra for the assets. They are included in the price.

Example

Here is a simple illustration and recap of the key components in the enterprise value formula (Calculating Enterprise Value):

Enterprise Value
The Value of Calculating Enterprise Value

There is much more than can be said about calculating enterprise value and to be fair, there is a whole industry that calculates the value of a business and does it in a way that incorporates multiple approaches. However, I think the value of Enterprise Value isn’t necessarily nailing down an exact formula as much as it is using a consistent methodology to help teams better assess past performance, evaluate future strategies and ensuring they on a path to reach the stakeholder’s longer term goals.

Look for another post on the Value of Enterprise Value in the weeks to come.

What Our Clients Say About Us: Client Testimonials

John Rogowski

CEO, Spoke Custom Products LLC, Atlanta GA 

“I spoke with multiple financial firms about the possibility of conducting a management buyout of a particular division.   Most of them seemed more interested in developing a long term relationship with the parent company than they were in securing the best possible deal for me.   I was then referred to Lantern Capital and things just clicked.   Chris listened carefully  to my vision for the business and patiently explained every step of the acquisition process.   He met every expedited timeline and used his extensive network to find me the best possible investment group.   I don’t know that a deal would have been completed without his guidance.   I would recommend him to anyone contemplating a similar transaction!”

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