Introduction to Corporate Finance

ONLINE CHAPTERS

As we begin to think more about company valuations, it is important to discuss in more detail the

difference between equity value and enterprise value. Equity value is the value available to shareholders,

whereas enterprise value is the company value available to all stakeholders, including creditors, debtors

and non-controlling (minority) interest holders. This is an important distinction, because often an

acquisition will trigger debt covenants requiring that the target company’s debt be repaid in the event of

a transfer of control. So, for example, if Company A pays $10 million for Company B’s equity but

Company B also has $6 million in debt, Company A will then have to pay Company B shareholders $10

million and also pay Company B debt holders $6 million. The enterprise value of this transaction is

therefore $16 million. This figure represents the takeover price, including obligations the buyer must

satisfy (such as buying out existing debtholders).

Acquirers and investment bankers often use multiples to estimate enterprise value, after which they

deduct the market value of the target’s debt to arrive at an estimate of the value of the target’s equity. It is

also common to use multiples to calculate equity value. The key determining which multiples calculate

equity value and which calculate enterprise value is the denominator of the multiple. A multiple with

EBITDA or revenue in the denominator will calculate enterprise value (that is, enterprise value is the

numerator of the multiple) because both EBITDA and revenue are available to all stakeholders. In

contrast, a multiple with earnings in the denominator will calculate equity value, because earnings are

available only to shareholders.^14

thinking cap

question

How do you identify appropriate

comparable companies? How

do you identify appropriate

precedent transactions?

14 EBITDA, by definition, represents earnings before subtracting interest expense, and is therefore available to all stakeholders. Specifically,

EBITDA is used to pay debtholders (through principal and interest payments) as well as shareholders (through dividends or share repurchases).

Earnings, or net income, are available only to shareholders, because earnings are net of interest payments to debtholders.

15 We are assuming earnings approximate cash flows.

example

Situation: You work in internal strategy for Taft Co.

and are preparing an acquisition bid for 100% of

W. Lee Co. Without synergies, W. Lee is expected

to generate $5 million, $8 million and $10 million in

after-tax earnings in each of the next three years,

respectively. With synergies, these earnings are

expected to be $6 million, $10 million and $12

million. Year 4 (t = 4) earnings inclusive of synergies

will be 3% higher than t = 3 earnings, and then

earnings are expected to grow by 3% in perpetuity.

Taft discounts using a rate of 9%.

W. Lee has two key rivals. The first, with similar

financial and operating characteristics and expected

earnings of $6.1 million next year, was recently acquired

for $210 million. The second rival is similar, except

that it is considered to be in a mature, low-growth

stage, and is trading at a P/E multiple of 17.3. What

acquisition bid do you recommend for W. Lee Co.?

Solution: Use each valuation method to identify

an appropriate range:

• Discounted cash flow: Discount the next three
  year’s earnings, including synergies, to arrive at

discounted cash flows^15 : [($6 million/1.09) +

($10 million/1.09^2 ) + ($12 million/1.09^3 )] = $23.19

million. Next, use the growing perpetuity formula

and the fact that year 4 cash flows are 3% higher

than the year before to find the present value

(at year 3) of all the cash flows in year 4 and

beyond, then discount that back to the present

time: [($12 million × 1.03)/(0.09 – 0.03) = $206

million, discounted back three years at 9%

equals $159.07 million.] Finally, sum to arrive

at the value for the entire company in today’s

dollars: $159.07 million + $23.19 million =

$182.3 million.

• Public comparables: The public rival has a P/E
  multiple of 17.3, which would imply that W. Lee
  is worth $86.5 million (17.3 × $5 million), quite
  a bit lower than the DCF estimate. However, we
  know this rival is low growth, whereas W. Lee is
  expecting 40% growth in year 1 and 20% growth
  in year 2. Therefore, the 17.3 multiple may be
  only appropriate for the terminal value (in year 3),
  when W. Lee is expected to reach a mature,