Enterprise value

Knowing your worth is always wise advice. In business, this means understanding enterprise value, a measure of a company’s total value.

“Understanding enterprise value, and knowing how to calculate it, is important for business owners because it can help them establish a fair sale price for their company,” explains Valérie Mathieu, Associate, Growth and Transition Capital, BDC. It can also help entrepreneurs develop their business strategy and improve tax planning.

Measuring enterprise value is not an exact science, however, and different methods can be employed to evaluate it.

Here is how to calculate enterprise value, why it important for business owners, and how you can grow the value of your business.

What is enterprise value?

Enterprise value is a measurement of a company's total value. It is a number obtained on the basis of a calculation rather than the actual sale price of the firm.

Calculating enterprise value can be difficult. For this reason, it is usually done by a professional business valuation specialist. Here in Canada, the professional designation in this domain is the Chartered Business Valuator title, offered by the CBV Institute.

Although all Chartered Business Valuators (CBV) have the required skill and experience to value your business, the professional of your choice may arrive at a different number than another professional, because estimating enterprise value is not an exact science. It implies a degree of professional judgement.

How to calculate enterprise value?

There are different ways to calculate enterprise value. Each approach will have its advantages and disadvantages, and may be used in different contexts. Some approaches may be more appropriate for a company in the early stages of growth, and others may be preferred for firms that have a specific business model.

“For instance, a management company derives its value mostly from its net assets, whereas a profitable service company will derive its value from its cash flow,” illustrates Mathieu. “So we will use a suitable valuation approach in each case.”

Here are the three main ways to calculate enterprise value.

1. Asset-based approach to calculating enterprise value

In the asset-based approach, enterprise value is equal to the sum of a company’s assets minus its liabilities, plus its long-term debt. In other terms, enterprise value is equal to equity value plus long-term debt.

In practice, this entails estimating the fair market value of every asset owned by the company, one by one. This is relatively straightforward for tangible assets, like a piece of machinery or a building, but it can be more challenging when it comes to intangible assets. These include trademarks, customer lists and patents, for example.

“In this case, when there are many intangible assets and especially when there is goodwill, it may be more appropriate to use the cash flow-based approach,” says Mathieu.

The asset-based valuation approach is often used to assess companies that are rich in physical assets, but without goodwill or intangible assets, like management companies or real estate holdings.

Does enterprise value include cash?

In the asset-based approach, cash can be included as part of the total assets. However, most professionals consider cash as part of net debt, meaning it reduces the amount of long-term debt factored into the enterprise value.

Does enterprise value include debt?

In the asset-based approach, debt is included as part of liabilities.

2. Income-based approach to calculating enterprise value

The income-based approach of estimating enterprise value, the most common among the three presented here, consists in estimating the value of a company using its expected future cash flows, which are discounted back to their present value.

“In this approach, we try to estimate the current value of all the cash flows that the company will generate until it ceases operations,” explains Mathieu.

Mathematically, this approach estimates enterprise value by multiplying all future cash flows by a present value factor based on a discount rate.

Choosing a discount rate is a critical step because it impacts the present value of future cash flows, and reflects the risk of the cash flows as well as the opportunity cost of capital. The weighted average cost of capital (WACC) is the most commonly used discount rate. It represents the average rate of return required by all of the company's investors, including equity holders and debt holders.

3. Market-based approach to calculating enterprise value

In the market-based approach, enterprise value is estimated using empirical rules, multiples and formulas.

One common approach consists in calculating the enterprise value-to-EBITDA ratio for recent transactions, and applying this number to your own company’s EBITDA in order to estimate your enterprise value.

However, this is not as easy as it seems for two reasons. According to Mathieu, “First, you need to find data on transactions in your sector, but it may not always exist. For instance, if no comparable public companies have been sold, or if no private companies in your industry have revealed the details of their acquisition, no data will be available to you.”

“Second, even if you do find the data for companies in your industry, they may differ in subtle, yet important ways,” says Mathieu. “For instance, if you use information on a public firm, it will probably be much larger than yours. So it may be a stretch to think their enterprise value-to-EBITDA will be comparable to your company’s.”

In addition, if you were to find data on the recent sale of a company similar to yours, you need to keep in mind that the owner may have sold for less than the full company’s value for a number of reasons, for instance, ill health.

Enterprise value-to-sales is another common multiple used in the market-based approach.

Can a company have a negative enterprise value?

Mathematically, a company could have a negative value. In the income-based approach, for example, the cash flow could be negative. This could be the case for a young technology company investing heavily in product development.

In practice, however, a company will never be estimated to have a negative value. Instead, if it were to face severe financial distress, a firm could simply declare bankruptcy, bringing its value to zero.

Moreover, according to Mathieu, “business valuators will usually use multiple methods at the same time. And since they posit that the true enterprise value is the highest price a hypothetical buyer is willing to pay, a company will nearly always be found to have positive value.”

Why is enterprise value important for entrepreneurs?

• Sale of the company
  Perhaps the most important reason for knowing your company’s enterprise value is understanding what you could get if you sold it. Determining your business’ worth will help you plan your sale and maximize your return by setting realistic expectations and negotiating from an informed position.
• Investment and fundraising
  Having a business valuator estimate your company’s value will provide a clear picture of the company’s value to potential investors or venture capitalists. It will also give you leverage when negotiating investment terms and valuation with potential investors.
• Strategic planning
  Enterprise value can allow you to benchmark against competitors and assess market position. It can also inform strategic decisions related to growth, expansion or restructuring. In addition, enterprise value allows business owners to evaluate the effectiveness of their operations and profitability relative to market value, and provides insights into the company’s financial health and risk profile.

How to improve enterprise value?

Enterprise value can be improved in a number of ways. Looking at each approach can provide insights into how to make significant gains.

“If we look at the cash-flow based approach, we see that we have to either reduce the risk profile, that is, improve the discount rate and present value factor, or increase our cash flow,” illustrates Mathieu.

In turn, increasing cash flow can entail increasing revenue by developing a new product or entering a new market, for instance, or reducing costs by optimizing your production or simplifying the administrative structure.

“Making an acquisition is another option,” says Mathieu. “This would increase revenue and hopefully create synergies, thus improving cash flow.”

More broadly, business owners can improve enterprise value by working on the six key elements driving it, says Ali Lajevardi, Managing Advisor, BDC Advisory Services.

1. Leadership and management teams

Strategic buyers are looking for reliable and performing assets. As Lajevardi suggests, “Improving the strength and composition of your management team is a powerful strategy if you want to improve enterprise value.”

2. Business and operating model

A high-performing business and operating model coupled with well-articulated strategies will drive the value of your company by helping generate stable and growing cash flow as well as improving responsiveness to new market opportunities.

3. People and culture

Talent and skills are the cornerstone of success for any entrepreneurial organization. It is critical for small businesses to foster an engaging and collaborative culture. By encouraging innovation and continuous improvement, such a culture creates opportunities for exponential value growth overtime.

4. Business processes and technologies

Reliable, repeatable and digitized processes will help your company support higher levels of productivity and ensure the continuity of business operations. By decreasing your overall risk, they directly lead to an increased enterprise value.

5. Diversification

Diversifying both your customer base as well as your supplier network is crucial when it comes to enterprise value, says Lajevardi. Not only will it improve your revenue stability, but it will also widen your market reach, thus driving up the value of your business.

6. Financial health and performance

Your company’s financial position is a key element of enterprise value. “Profitability, working capital and cash flow are three vital metrics you need to strengthen if you want to improve the value of your company,” explains Lajevardi.

Next step

Learn how valuation affects buyers and sellers when determining a fair price for a business transfer. Download BDC’s free guide for entrepreneurs: Business Valuation.