We developed this blog entry to answer questions some of our clients had about describing the value of the company we were acquiring on their behalf.
Since most people are familiar with the construct of a home purchase and a mortgage the easiest and most general explanation is that the value of a home is the price you paid for it. If you borrow money from a bank to fund the purchase then that debt plus the amount you put towards the purchase equal the home’s value:
Purchase Price = Amount put down + Amount of mortgage
We can translate that to the value of an acquisition in much the same way:
Enterprise Value of a company = Equity + Debt
Headlines will often read that a certain company is the most valuable in the world. Reading more closely that value will be referred to as either market capitalization or enterprise value.
The market capitalization of a publically traded company is the value of its current share price multiplied by the number of shares outstanding.
The enterprise value of a company is the market capitalization of a company plus its outstanding debt. For simplicity, we omit the discussion around cash and excess cash.
Enterprise Value of a company = market capitalization (equity) + Debt
So in practice consider this situation. The enterprise value of a target company is established at $30 million. The company holds $10 million of debt. Therefore:
Enterprise Value = Equity Value + Debt
$30 million = $20 million of equity + $10 million of debt.
At a hypothetical deal closing the acquirer could show up with $20 million in cash and assume the debt of $10 million or the acquirer could show up with $30 million where the seller would use $10 million of the cash payment to extinguish the debt outstanding. In either case the acquirer would own an asset that was at that moment valued at $30 million dollars.