1. Calculating Enterprise Value
In practice, we can calculate enterprise value by taking a company's equity
market capitalization or market cap and adding its debt minus its cash,
debt minus cash is often called net debt.
Regarding debt, you're primarily concerned with interest bearing debt
like bonds or your revolving line of credit,
things like accounts payable and deferred revenues are not interest bearing
liabilities and aren't considered a form of debt.
So here's an example, in millions of dollars
of calculating a company's net debt. On the balance sheet, this company
has short term debt of $5 billion, long term debt of $35 billion,
and therefore it has gross debt of $40 billion.
But netting against that, this company has cash and cash equivalents of
$10 billion. Therefore, it's net debt is $30 billion.
There are two important points to make here about cash in this equation.
One is that it's assumed that cash can be netted against debt that
needs to be repaid. So for that reason, you can think about the
cash as offsetting the debt, because in the situation where it's required,
that cash could be used to pay off some of the debt.
The other thing to note is that cash is not an operating asset
that generates cash flow for the business. So in that sense,
it wouldn't be included in the firm value.
So cash is netted out from the total debt to get the net
debt. Now, let's look at another example of calculating net debt for a
company that actually has a positive net cash position, as this can definitely
happen. So imagine a company now that has short term debt of $5
billion, no long term debt, and therefore gross debt is $5 billion.
We then need to deduct from that the cash position,
which is $20 billion, and therefore that results in a net debt position
of negative $15 billion. We would rephrase that to say it has a
net cash position of $15 billion. So going back to our enterprise value
calculation or equity value calculation, we would add the 15 billion of
cash to the asset value to get the equity value,
or we would deduct the 15 billion of cash from the equity value
to arrive at the enterprise value. Let's look at a quick demonstration.
2. Let's practice!