1. Value of a House
So let's look at an example to further clarify enterprise value,
debt and equity. Imagine three different houses, each of these houses is
financed in its own way. The first house is financed with a $100,000
mortgage and $400,000 in equity. The second house is financed with $400,000
mortgage and $100,000 in equity. And finally, the third one is financed
with a $250,000 mortgage and $250,000 in equity. So the question is,
what is the worth of each of these houses?
Well, it's actually a trick question, because all three are exactly the
same, $500,000. The funding mix for the house does not impact its valuation.
So thinking about a home and the mortgage on a home is an
easy way to think about enterprise value and equity value.
If someone asks you what your home is worth,
you would typically give them the value of the whole house,
the enterprise value, if you will, rarely would you tell them the equity
value. So in business valuation, we think of it in the same way,
if you want to think about what the entire company is worth,
then you're thinking about its enterprise value. If you want to know what
just the amount for the shareholders, and that's the equity value.
2. Let's practice!