Enterprise, equity, & book values

Book value

The book value of a business is the sum total of the assets under control. You can use the balance sheet of a business to calculate its book value. Think of the book value as the cost of the ingredients needed to bake a cake. Even though you know the purchase value of each ingredient (asset), you don't know the order of operations, sequence, and other intangible aspects that make the assets work together and optimally. As a result, the book value often undervalues the true value of a business. 

Equity value

The equity value is the amount one would need to purchase a company from all of its equity holders. For publicly traded companies, you can calculate the equity value by the multiplying the price per share with the number of outstanding shares. The equity value tells you the minimum you'd have to spend to acquire full control of the company. Often you'll pay more in order to convince all equity holders to sell their shares to you. The excess you spend above the calculated equity value can be considered goodwill. 

Unfortunately, the equity value gives you a baseline acquisition price. There's no way to mathematically determine the right amount of goodwill to pay. The equity value is the floor and not the ceiling on the acquisition price. 

Enterprise value

Of the three, the enterprise value is perhaps the most informative valuation. It is the value of the operations of the business. Unlike the book value (of assets), the enterprise value recognizes the way in which the assets are used together. Optimal use of the assets will result in a high enterprise value. 

The enterprise value can be calculated ine on two ways. The easy way is to take the equity value, add debt, and subtract cash.

Enterprise value = equity value + debt - cash

The other way to calculate enterprise value is to realize that this value represents the sum of the cash flows that will come from use of the assets in a certain (optimal) way. Those cash flows, discounted to the present, represent the enterprise value - the value of the operations of the business. 

Back to the social media post

Now that we have a better understanding of book, equity, and enterprise values, we can see the mistake in the post above. A business can't have an enterprise value greater than its book value of assets because the former is a component of the latter. The post author is trying to convey that the business will have intangible assets not captured by the accounting. Those intangible assets, such as client loyalty or referral, will be captured in the enterprise value of the company, because those intangible assets will help the company optimally utilize its tangible assets. 

Let us know if you have any questions about valuation.