**This is an edited version of my previous post to clarify some issues related to the calculation of EV as well as other minor edits**

I have come across a number of questions on this and other forums regarding the calculation of “Enterprise Value” (EV), how to deal with minority interest and why we deduct cash in the EV calculation. This topic seems to be an interview favorite and almost never fails to generate some interesting replies. However, in my view at least, even a lot of interviewers asking the question fail to fathom exactly what it is they are asking or its implications, instead expect some rote formulaic response they deem as correct, something akin to what is written up in Wikipedia or the like.

For most young budding IB analysts and others in the field, the calculation of EV is fairly straightforward: EV=Market Cap + Debt – Cash. This is usually the standard answer for standalone companies. It gets more complex when consolidated financials are involved, and the term “minority interest” (MI) rears its ugly head. An interview question would be posited to some starry-eyed candidate dreaming of striking it big: “Calculate the EV of XYZ that owns 51% in ABC with so and so cash and debt involved." The seemingly simple question really disconcerts some people, leading to a flurry of posts as to what exactly EV is, why we subtract cash, and how does one calculate EV in cases of consolidated financials involving minority interest?

The purpose of this post is to present this writer’s view that this seemingly innocent question is not deserving of a simple all encompassing reply, and that many considerations need to be taken into account. Sometimes so many that the entire relevance of the question needs to be re-thought. For the purpose of this discussion, let us consider the case in which a majority (>50% ownership) or controlling interest (which can sometimes include less than 50% ownership) results in consolidated financials involving a minority interest.

Let us begin first with what exactly is Enterprise Value:

Simplistically, it is the “Value of Operations”. For a firm, ignoring capital structure for the moment,

Value of Firm =PV(Net assets today + Future Growth Opportunities)

Future growth opportunities from core operations can be called “Value of Operations”, but in order to have an ongoing operations, you need an asset base today, an operating asset base for working capital needs. So, we can rewrite the above equation as:

Value of Firm =PV(Net Operating Assets today + Net Non-Operating Assets today +
Future Growth Opportunities)
=PV (Operations + Net Non-Operating Assets)
=Value of Operations + Net Non-Operating Assets today

We refer to Enterprise Value ("EV") as the “Value of Operations”. It would be intrinsic amount the market is valuing the core operating assets of the company. Since the value of the firm is the total amount which is split between capital providers, it follows, that to ordinary equity holders, their share, which is typically defined as the “market cap” is:

Mkt. Cap=EV + Current Value of Net Non-Operating Assets – (Debt + Preferred + Other senior Claims)

The value of the firm comes from the value of operations + the net value of non-operating assets. (Strictly speaking, adding debt, in many cases depending on the operating regime, will add value to the enterprise because in most cases, interest on debt is tax deductible – the “tax shield” and the company will pay less taxes.) In the subordination hierarchy, debt & preferred holders will get seniority to ordinary equity holders, who will get the residual, which is why the debt, preferred and senior claims are subtracted to get market cap. So to get EV, you’d have to add them to market cap. A lot of questions concern why we subtract “cash” in calculating EV. This above equation shows why – more on this below.

The Net-Non operating assets usually consist of “excess cash”, but could also include other items like appreciated land, IP, patents or investments, or even certain liabilities and commitments not related to the core operations of the firm. It’s important to consider if these are not being double-counted in the EV itself. EV is an IMPLIED figure, after taking into account what the market is valuing the stakeholder stakes (debt, common equity, preferred, etc) and all the other identifiable assets. A lot of discretion is sometimes required on the analyst’s part to evaluate the “operating” vs. passive vs. off-balance sheet components of value and understand what is reflected in the market prices and at what discount/premium, but the basic question the analyst is trying answer when calculating the EV is: how much are the operations by themselves worth, given how the market is valuing the stakeholder stakes and net assets?

In addition to the calculating the market implied EV, an analyst should also conduct and analyze the FCF (free cash flow) to the firm to validate this number. A secondary but extremely important point is how to calculate these FCFs, especially the treatment of stock based compensation, as seriously underestimated and misunderstood element of valuation – I’ve already written about this controversial topic on this forum in the past.

For simplicity and ease, we usually deduct ALL the cash & equivalents to derive a value for EV, rather than just the “excess cash”. Reason: Who has the time to adjust for what is excess and what is not? Strictly speaking, this is incorrect. The going “explanation” for such logic is that if we were to “purchase” the enterprise, we would assume all the debt, but this would be offset by the cash at hand. The main flaw in this logic (other than the fact that one rarely assumes all the debt without restructuring it some way in any acquisition), is that the fact that the market cap and debt values assume the firm is a going concern, and to keep the concern going, you need operating cash at hand for working capital. So unless you’re planning on liquidating the enterprise, all that cash is not really going to be available, even if you were to “purchase” the entire firm and assume the debt. Only the “excess” cash will be available for that purpose of retiring the debt. But it is simply easier to deduct the whole amount. These calculated EV values are mainly used for comparison purposes as a ratio of some other metric, not as proxies for the actual price a firm might be acquired for – that would be far more complicated – involving premiums, transaction costs, breakup fees, debt covenants, synergies, restructuring costs, tax impacts etc.

Some purists would argue that the interest on excess cash is already incorporated into the FCF thus thereby making the “excess” not excess, but that is usually not very significant and distracting from the discussion. If this interest were a significant portion of the cash flows, one would have to consider the fact that the market would take this into account in determining the cost of capital to discount the company’s FCF – the company’s WACC would change, because a large component of its earnings and cash flow would be essentially be lower risk, and the market cap would still reflect the amount appropriately. But this still does change the fact that the “value of operations” should only include the level of cash that is required for operational needs.

So now, let us move on to the case where there is a “minority interest” (MI). MI arises when a company owns more than 50% or exerts a significant controlling influence over another entity “the sub” (and in some cases even if the ownership is less than 50%). In that case, accounting rules, at least US GAAP, usually require consolidating the sub’s financials into the parent company, as if it were 100% owned. The portion of the net EQUITY that is not owned by the parent at the time of the acquisition, is listed as Minority Interest. Additionally in the income statement, this is also deducted from the Net income usually with a “Non-controlling interest” label, because the income statements too are consolidated as if they were one company, 100% owned.

So, when one tries to calculate EV for a company with MI, some interesting phenomenon results. For simplicity, let us just assume there is only one sub involved. Bear in mind that MI is a “book” value that is derived at the time of acquisition. It can vary dramatically given time and change in the operating or value profile of the sub (i.e. has it suddenly become very valuable due to PE expansion or recently become very profitable) since the acquiring of the ownership stake. Unless the company is in a distressed state, the current book value of debt is probably a good assumption for market value for analysis purposes. It is reasonable to expect that the market cap of the parent would include the market value of the percentage ownership of the equity in the sub. So, when asked the question, what is the EV of a parent that owns a less than 100% stake in a sub, what is the correct response?

If we use the standard formula: EV=Mkt Cap + Debt – Cash, we realize that Mkt. Cap is a blended figure, i.e. Mkt. Cap of the parent + % of the market value of the equity of the sub. However, the Debt & Cash are consolidated as if 100% of the sub was owned. Thus we get a spurious number. What if we add MI to that figure? Well, then we get a blended Market Cap + a historical MI + Debt – Cash; which if not a lot of time has passed and not a lot of changes have occurred to the operating or value profile of the sub, would be a fairly good estimate of the SUM of the EV’s of the parent and sub (usually this is not the case – the accounting MI value is not very useful if you’re doing any serious analysis). But nevertheless, now that you’ve calculated this new value what is the relevance of this figure? Not much actually, from an economic perspective. Some would say, when calculating ratios like EV/EBITDA or EV/Sales, this aggregate value makes sense to use, since the EBITDA and other income statement metrics are consolidated as if 100% (one has to be careful if there are intercompany transactions between the parent and sub – for instance if a company owns a part of a supplier, or its customer – which can have serious implications depending on the analysis). Assuming there aren’t any intercompany complications, if you do construct a ratio like EV/EBITDA by adding back MI, you’ll get in the numerator, a summed EV of the parent +sub, and in the denominator, a summed EBITDA of the two companies. Does this result make sense? That is the equivalent of looking at (a+b)/(x+y) for the combined entity whereas each company individually would have a ratio a/x and b/y. Depending on the numerical values of each company’s actual EV’s and EBITDA’s, it could give some seriously irrelevant numbers that have the illusion of looking relevant – for example, if a majority of the EBITDA comes from one entity and majority of the EV of the total derives from another. Or if the companies are in different industries, where the EV/EBITDA’s are expected on average to be different, this further adds to the complication as to the validity and usefulness of a combined number. In my view, this combined ratio too is a spurious number. And what is the point of all this calculation? Why do we even care about this jumbled mixed up EV/EBITDA figure? Beats me. If you’re trying to build a comp table, there are more relevant ways to gauge relative value – try using pure plays.

What about subtracting the MI from the EV calc? Again, now you have a Mkt. Cap that is already reflecting the correct % of the earnings contribution, assuming the markets are pricing the value correctly. You have the consolidated debt and consolidated equity. Subtracting out MI gives you what? I’m not even sure there is a term for whatever calculated abomination that results. Excluding MI altogether. Well, to the extent that the cash and debt’s are in equal proportions in both the parent and sub, that might be the best option to get to the most accurate ‘quick’ estimate of the combination’s EV (since the cash and debt would cancel out). But again, these are questionable assumptions, and what good is a combined EV if the companies are in different industries and the ratio is constructed in that (a+b)/(x+y) way? The safest way, in my view, is to first ask, what is it you’re exactly trying to calculate, why, and then use a DCF to isolate the cash flows relevant to the stakeholder to which they matter and value those using current market values and projections.

Not to belabor the discussion, but another interesting complication arises from the debt subordination structure. Let us assume, for example, A owns 51% of B. B has little cash, assets and equity but a lot of debt. A by itself has no debt. In that case, 100% of B’s debt would be consolidated onto the parents books. So now if you look at the parent, it looks like it has a ton of debt. Is this debt real? Consider the situation in which B goes bankrupt. B’s debt holders will normally only have a claim on B’s assets – NOT A’s (if A structured the deal intelligently). So in that case, despite a lot of debt showing up in the consolidated A’s financials, it is technically not something A’s shareholders should have to worry about too much. Their exposure would be to the extent of their EQUITY investment in B. At worst they’ll lose what they invested – not more. This “loss isolation” principle is basically how PE (private equity) funds operate and also where they derive a lot of their value – if one entity goes belly up, the debt holders do not have claim to the other investments or assets of the PE fund - usually only to those assets secured in the entity that went bankrupt. The PE fund takes a loss on the equity, which was small relative to the EV of the overall investment, shrugs, and moves on.

Thus one might even reasonably ask, what is the point of calculating EV for a company that has consolidated controlling interests in other companies, especially when large amounts of debt are involved? Assuming you have to, so what is the right way to do it? Well, again it depends on what exactly you are trying to do. Why do you want to calculate this EV? If it is for getting valuation ratios in a comp table, it would be better to use pure plays. Else use a DCF to get the most accurate estimate of the relevant cash flows to the relevant stakeholders. There is no substitute for digging into the footnotes and historical filings to figure out or estimate what assets belong to whom. Certainly, a rote answer like EV=Mkt. Cap + MI +Debt – Cash might suffice in an interview, but I would hazard the real answer is a little more complicated, so much so that one might even ask what exactly the relevance of such a question is and does the person posing the question really understand what it is and why they are asking.