Equity and EV (advanced)

Question 1

Can you describe a few of the additional items that might be a part of Enterprise Value‚ beyond Cash‚ Debt‚ Preferred Stock‚ and Noncontrolling Interests‚ and explain whether you add or subtract each one?

Answer 1

Items that may be counted as Cash-Like items and subtracted:
- NOLs: SUBTRACT PV of NOLs as reduce future taxes; depends on company and deal structure
• Short-Term and Long-Term Investments: b/c theoretically you can sell these off and get extra cash. May not be true if they’re illiquid.
• Equity Investments: Any investments in other companies where you own between 20-50%; Earnings are below the line b/c taxed at the affiliate level –> this one is also partially for comparability purposes since revenue and profit from these investments show up in the company’s Net Income‚ but not in EBIT‚ EBITDA‚ and Revenue

Items that may be counted as Debt-Like items and added:
• Capital Leases: Like Debt‚ these have interest payments and may need to be repaid.
• (Some) Operating Leases: sometimes you need to convert Operating Leases to Capital Leases and add them as well‚ if they meet criteria for qualifying as Capital Leases
• Unfunded Pension Obligations: These are usually paid w/ something other than the company’s normal cash flows‚ and they may be extremely large.
• Restructuring/Environmental Liabilities: similar logic to unfunded pension obligations (other off balance sheet accounts)

Question 2

Wait a second‚ why might you add back Unfunded Pension Obligations but not something like Accounts Payable? Don’t they both need to be repaid?

Answer 2

• The distinctions are magnitude and source of funds. 99% of the time‚ A/P is paid back via the company’s cash flow from it’s normal business operations and it tends to be very small.
• Items like Unfunded Pension Obligations‚ by contrast‚ usually require additional funding (e.g. the company raises Debt) to be repaid. These types of liabilities also tend to be much bigger than Working Capital / Operational Asset and Liability items.

Question 3

Are there are any exceptions to the rules about subtracting Equity Interests and adding Noncontrolling Interests when calculating Enterprise Value?

Answer 3

Ask yourself if you are showing apples to apples in the numerator or denominator, and what are you showing for comparable companies or elsewhere in your analysis.

• You pretty much always add Noncontrolling Interests b/c the financial statements are always consolidated when you have control over a subsidiary
- You do not need to add back NCI if you strip out the NCI’s ownership of EBITDA (i.e. reporting earnings at the parent’s ownership level)

Equity in Affiliates = Shown below the line yet the market value already incorporates. Back it out as you are not including earnings in affiliates in EBITDA

• But with Levered FCF (FCF to Equity)‚ typically you’re starting w/ Net Income Attributable to Parent Company‚ which already includes Net Income from Equity Interests.
• Normally you subtract that out in the CFO section of the SCF so you would still subtract Equity Interests if you calculate FCF by going through all the items in that section.
• But if you have not subtracted out Net Income from Equity Interests (if you’ve used some other formula to calculate FCF)‚ you should NOT subtract it in the Enterprise Value calculation - you WANT to show its impact in that case.
• This is a very subtle point‚ most bankers would probably not understand the explanation above.

Question 4

Should you use the Book Value or Market Value of each item when calculating Enterprise Value?

Answer 4

Technically you should use Market Value for everything. In practice‚ however‚ you usually use market value only for the Equity Value portion b/c it’s difficult to determine market values for the rest of the items in the formula - so you take the numbers from the company’s Balance Sheet.

Question 5

What percentage dilution in Equity Value is “too high?”

Answer 5

• There’s no strict rule here‚ but most bankers would say that anything over 10% is odd.
• If the basic Equity Value is $100M and the diluted Equity Value is $115M‚ you might want to check your calculations - it’s not necessarily wrong‚ but over 10% dilution is unusual for most companies. And something like 50% dilution would be highly unusual.

Question 6

How do you factor in Convertible Preferred Stock in the Enterprise Value calculation?

Answer 6

The same way you would factor in normal Convertible Bonds: if it’s in-the-money‚ you assume that new shares get created‚ and if it’s not in-the-money‚ you count it as Debt.

Question 7

How do you factor in Restricted Stock Units (RSUs) and Performance Shares when calculating Diluted Equity Value?

Answer 7

• RSUs should be added to the common share count‚ b/c they ARE just common shares ONLY subject to VESTING requirements
• Performance Shares are similar to Convertible Bonds‚ but if they’re not in-the-money (the share price is below the performance share price target)‚ you do not count them as Debt - you ignore them altogether. If they are in-the-money‚ you assume that they are normal common share and add them to the share count.

Question 8

What’s the distinction between Options Exercisable vs. Options Outstanding? Which one(s) should you use when calculating share dilution?

Answer 8

• Options Exercisable vs. Options Outstanding: normally companies put in place restrictions on when employees can actually exercise options - so even there are 1M options outstanding right now‚ only 500K may actually be exercisable EVEN IF they’re all in-the-money.
• There’s no correct answer for which one to use here. Some people argue that you should use Options Outstanding b/c typically‚ all non-exercisable Options become exercisable in an acquisition‚ so that’s the more accurate way to view it.
• Others argue that Options Exercisable is better b/c you don’t know whether or not the non-exercisable ones will become exercisable until the acquisition happens.
• However you treat it‚ you need to be consistent with all the companies you analyze.

Question 9

Let’s say a company has 100 shares outstanding‚ at a share price of $10 each. It also has 10 options outstanding at an exercise price of $5 each - what is its Diluted Equity Value?

Answer 9

• The Basic Equity Value is $1000 (100 * $10 = $1000). To calculate the dilutive effect of the options‚ first you note that the options are all “in-the-money” - their exercise price is less than the current share price.
• When these options are exercised‚ 10 new shares get created - the share count is now 110 rather than 100.
• However‚ in order to exercise the options‚ we had to “pay” the company $5 for each option (the exercise price). As a result‚ it now has $50 in additional cash‚ which it uses to buy back 5 of the new shares created.
• So the fully diluted share count is 105 and the Diluted Equity Value is $1‚050.

Question 10

Let’s say a company has 100 shares outstanding‚ at a share price of $10 each. It also has 10 options outstanding at an exercise price of $15 each - what is its Diluted Equity Value?

Answer 10

$1000. In this case‚ the options’ exercise price is above the current share price (options are not in-the-money)‚ so they have no dilutive effe

Question 11

A company has 1M shares outstanding at a value of $100 per share. It also has $10M of convertible bonds‚ with par value of $1000 and a conversion price of $50. How do I calculate diluted shares outstanding?

Answer 11

First‚ note that these convertible bonds are in-the-money b/c the company’s share price is $100‚ but the conversion price is $50. So we count them as additional shares rather than debt.
• Next‚ we need to divide the value of the convertible bonds $10M by the par value $1000 to figure out how many individual bonds there are ($10M / $1000 = 10‚000 convertible bonds).
• Next‚ we need to figure out how many shares this number represents. The number of shares per bond is the par value divided by the conversion price: $1000 / $50 = 20 shares per bond
• So we have 200‚000 new shares (20 * 10‚000) created by the convertibles‚ giving us 1.2M diluted shares outstanding.
• We do not use the Treasury Stock Method with convertibles b/c we do not pay the company anything to “convert” the convertibles - it just becomes an option automatically once the share price exceeds the conversion price.

Question 12

• Let’s say that a company has 10‚000 shares outstanding and a current share price of $20. It also has 100 options outstanding at an exercise price of $10.
• It also has 50 Restricted Stock Units (RSUs) outstanding
• Finally‚ it also has 100 convertible bonds outstanding‚ at a conversion price of $10 and par value of $100.
• What is its Diluted Equity Value?

Answer 12

• First‚ let’s tackle the options outstanding: since they are in-the-money‚ we assume that they get exercised and that 100 new shares get created.
• The company receives 100 * $10 = $1000 in proceeds. Its share price is $20 so it can repurchase 50 shares with these proceeds. Overall‚ there are 50 additional shares outstanding now (100 new shares - 50 repurchased).
• The 50 RSUs get added as if they were common shares‚ so now there’s a total of 100 additional shares outstanding.
• For the convertible bonds‚ the conversion price of $10 is below the company’s current share price of $20‚ so conversion is allowed.
• We divide the par value by the conversion price to see how many new shares per bond get created: $100 / $10 = 10 new shares per bond
• Since there are 100 convertible bonds outstanding‚ we therefore get 1‚000 new shares (100 convertible bonds * 10 new shares per bond)
• In total‚ there are 1‚100 additional shares outstanding. The diluted share count is therefore 11‚100.
• The Diluted Equity Value is 11‚100 & $20 = $222‚000

Question 13

This same company also has Cash of $10‚000‚ Debt of $30‚000 and Noncontrolling Interests of $15‚000. What is its Enterprise Value?

Answer 13

• Enterprise Value = Diluted Equity Value - Cash + Debt + Noncontrolling Interest
• Enterprise Value = $222K - $10K + $30K + $15K = $257K