One of the topics I will return to often on these virtual pages is that of how consultancies can increase enterprise value. But before starting down that road, I should clear up a common source of confusion by explaining the difference between the terms “enterprise value” and “equity value.” The former is the total value of the business, including value held by its equity owners and its debt owners. The latter is limited to the value held by its equity owners. Mathematically, enterprise value is equal to equity value plus debt and minus cash. Or, conversely, equity value is equal to enterprise value less debt and plus cash.
The House Analogy
One of best ways to understand the difference between the two terms is to consider another major asset in many portfolios—a house. Consider a house that has a $600,000 mortgage loan and is sold for $1,000,000. In this case the “enterprise” (i.e. house) value is $1,000,000 but the equity value is only $400,000. That is, the value of the house is held by two different claims holders: the debt provider (i.e. the mortgage lender) and the equity provider (i.e. the owner).
I find that the debt difference is generally easily understood but the waters can get a bit choppy when considering the impact of cash. In the house analogy, cash would be equivalent to the homeowner’s rare, 15th century Ming vase worth $50,000. On some level, the vase may be considered part of the house, as it is kept in the home and adds to the owner’s enjoyment of the residence. However, it is clearly a distinctly separate asset that may easily be removed without adversely impacting the functional value of the house. Should the selling homeowner offer to include the vase in his sale of the house, he would expect to be paid $1,050,000 rather than $1,000,000. Note that this does not change enterprise value, as the physical structure itself continues to carry a $1,000,000 value, but it does increase equity value, as the seller would expect to walk away with net proceeds of $450,000 rather than $400,000.
The same analysis holds true in selling a business. Cash on the balance sheet of the company being acquired is a distinctly separate asset that may easily be removed without adversely impacting the functional value of the business. This is not the case with other assets such as accounts receivable, computer equipment and office furniture, all of which would need to be replaced by further buyer cash outlay if removed by the seller (note that the treatment of accounts receivable specifically and working capital generally is another topic of frequent confusion but one that deserves its own, separate post). Should the buyer acquire a business with $50,000 of cash, the enterprise value is unaffected but the equity value received by the seller should be $50,000 higher.
Why is This Important?
The reason this is important is that there must be an apples-to-apples standard for talking about valuations of consultancies that may have radically different balance sheets. Enterprise value provides just such a standard in that it is independent of cash and debt balances and therefore can be used as an objective measure of relative values for companies across the sector. In the technology consulting space, the typical price-setting mechanism is a multiple of earnings before interest, taxes, depreciation and amortization (“EBITDA”). Because EBITDA excludes the impact of debt and cash on interest income/expense and income tax expense, it provides a great measure for valuing consultancies without regard to capital structure differences. Thus, we can talk in terms of one consultancy being worth 6x EBITDA while another is worth 5x, where the spread is due to business quality differences and not to choices regarding cash retention or debt financing, which are irrelevant to the fundamental value of the business. It is those business quality differences that should be the focus in evaluating consultancies and, with this valuation nomenclature now cleared up, they can be the focus of upcoming Above the Clouds pieces.