This video will teach you how to answer a common interview question: what happens to a company’s Enterprise Value if its cash balance increases?
You’ll learn why Enterprise Value stays the same, as well as two different methods of understanding why this is the case.
By http://breakingintowallstreet.com/ "Financial Modeling Training And Career Resources For Aspiring Investment Bankers"
Table of Contents:
1:12 The Answer
2:50 The Explanation According to the Meaning of Enterprise Value
6:09 Why Cash is Implicitly Reflected in Equity Value
8:04 Real-Life Analogy Using a Home Purchase
12:15 Recap and Summary
What Happens to Enterprise Value When a Company’s Cash Balance Changes?
Question the Other Day: “If a CEO of a company picks up $100 of cash on the ground and puts it in the company’s bank account, what happens to the company’s Enterprise Value?”
Answer: Enterprise Value stays the same!
But… how is that possible? In the Enterprise Value formula, after all, you subtract Cash:
Enterprise Value = Equity Value + Debt – Cash + Non-controlling Interests + Preferred Stock + Unfunded Pensions – Other Investments… (and possibly other items)
That’s how you *calculate* Enterprise Value, but it’s not what it *means.*
Meaning: Enterprise Value represents the value of a company’s core business operations to ALL the investors in the company
Equity Value: Represents the value of *everything* the company has, but only to the Equity Investors.
So when you calculate Enterprise Value starting with Equity Value, you add items when they represent *other* investors or long-term funding sources (Debt, Preferred Stock, etc.) and you subtract items when they are *not* related to the company’s core business operations (e.g., “side activity” assets, cash or excess cash, investments, real estate…).
Back to $100 of Cash
So a better question to ask is the following: “Is this $100 of cash a part of the company’s CORE business operations?”
And the answer is no! Receiving this cash does nothing to make the business more or less valuable.
When this happens, the company’s Equity Value increases and its Cash balance also increases. Those two changes cancel each other out, and so Enterprise Value stays the same.
Remember that Equity Value *implicitly* reflects the company’s cash balance already – it would make no sense if, for example, the cash balance were $500 and the company’s Equity Value were less than $500. It should always be greater than or equal to the cash balance.
Otherwise, you could buy one share of the company and effectively get “free money,” since its cash per share would exceed its price per share.
So whenever “free money” comes into the company, as it does here, its Equity Value should increase.
Another Way to Think About This Topic
Consider the “home buying” analogy often used to describe
Enterprise Value: a $500K house is worth $500K regardless of the mortgage / down payment (or debt / equity) split.
If you pay $100K and take out a $400K mortgage, the house is worth $500K. And it’s worth the same if you pay $250K and take out a $250K mortgage.
The house’s “Enterprise Value” would increase if you and the owner found an extra, hidden room or figured out the house had more space than you initially thought. That extra space increases the house’s intrinsic value because buyers are now willing to pay more for the house.
But if you find something like gardening tools or random supplies in the basement, those are NOT core to the home’s value and won’t affect anything.
The owner might charge you more upfront to buy the home if those supplies come with it, but you’ll turn around and sell those supplies for cash right after you buy it… so you still pay the same net price for the house.
And that’s what it’s like when the CEO picks up $100 of cash on the ground: yes, the company has more money now, but that extra cash does NOT mean its Enterprise Value is higher.
The Moral of the Story
When you get a question like “What happens to Enterprise Value when X or Y changes?” in an interview, instead of thinking about the formula for Enterprise Value, consider whether or not the change relates to the company’s *core business operations.*
In other words, could it potentially affect the company’s revenue or EBITDA?
With Cash, Debt, Preferred Stock, Unfunded Pensions, etc., the answer is “no” because they only impact interest, dividends, and other items that have no impact on revenue or EBITDA.
If this change *does* impact the company’s core business operations, then its Enterprise Value will change in some way.
If it does *not* impact core business operations, then its Enterprise Value will not change.
RESOURCES:
http://youtube-breakingintowallstreet-com.s3.amazonaws.com/106-12-Cash-Enterprise-Value-Impact.pdf
