Leveraged Buyouts

CHAPTER 2

What Is Value?

Before getting into the leveraged buyout analysis, a valuation overview is in order. The most important question before even getting into the mechanics is “What is value?” To help answer this question, we note there are two major categories of value:

BOOK VALUE

The book value can be determined by the balance sheet. The total book value of a company’s property, for example, can be found under the net property, plant, and equipment (PP&E) in the assets section of the balance sheet. The book value of the shareholders’ interest in the company (not including the noncontrolling interest holders) can be found under shareholders’ equity.

MARKET VALUE

The market value of a company can be defined by its market capitalization, or shares outstanding times share price.

Both the book value and market value represent the equity value of a business. The equity value of a business is the value of the business attributable to just equity holders—that is, the value of the business excluding debt lenders, noncontrolling interest holders, and other obligations.

Shareholders’ equity, for example, is the value of the company’s assets less the value of the company’s liabilities. So this shareholders’ equity value (making sure noncontrolling interest is not included in shareholders’ equity) is the value of the business excluding lenders and other obligations—an equity value. The market value, or market capitalization, is based on the stock price, which is inherently an equity value since equity investors value a company’s stock after payments to debt lenders and other obligations.

ENTERPRISE VALUE

Enterprise value (also known as firm value) is defined as the value of the entire business, including debt lenders and other obligations. We will see why the importance of enterprise value is that it approaches an approximate value of the operating assets of an entity. To be more specific, “debt lenders and other obligations” can include short-term debts, long-term debts, current portion of long-term debts, capital lease obligations, preferred securities, noncontrolling interests, and other nonoperating liabilities (e.g., unallocated pension funds). So, for complete reference, enterprise value can be calculated as:

We will explain why subtracting cash and cash equivalents is significant. So, to arrive at enterprise value on a book value basis, we take the shareholders’ equity (book value) and add back any potential debts and obligations less cash and cash equivalents. Similarly, if we add to market capitalization (market value) any potential debts and obligations less cash and cash equivalents, we approach the enterprise value of a company on a market value basis.

Here is a quick recap:

Note: “Potential debts and obligations” can include short-term debts, long-term debts, current portion of long-term debts, capital lease obligations, preferred securities, noncontrolling interests, and other nonoperating liabilities (e.g., unallocated pension funds).

Let’s take the example of a company that has shareholders’ equity of $10 million according to its balance sheet. Let’s also say it has $5 million in total liabilities. We will assume no noncontrolling interest holders in these examples to better illustrate the main idea. As per the balance sheet formula (where Assets = Liabilities + Shareholders’ Equity), the total value of the company’s assets is $15 million. So $10 million is the book equity value of the company.

Let’s now say the company trades in the market at a premium to its book equity value; the market capitalization of the company is $12 million. The market capitalization of a company is an important value, because it is current; it is the value of a business as determined by the market (Share Price × Shares Outstanding). When we take the market capitalization and add the total liabilities of $5 million, we get a value that represents the value of the company’s total assets as determined by the market.

However, in valuation we typically take market capitalization or book value and add back not the total liabilities, but just debts and obligations as noted earlier to get to enterprise value. The balance sheet formula can help us explain why:

Using this equation, let’s list out the actual balance sheet items:

To better illustrate the theory, in this example we assume the company has no noncontrolling interests, no preferred securities, and no other nonoperating liabilities such as unallocated pension funds; it has just short-term debt, long-term debt, and cash.

We will abbreviate some line items so the formula is easier to read:

Now we need to move everything that’s not related to debt—the accounts payable (AP) and accrued expenses (AE)—to the other side of the equation. We can simply subtract AP and AE from both sides of the equation to get:

And we can regroup the terms on the right to get:

Notice that AR + Inv. − AP − AE, or current assets less current liabilities, is working capital, so:

Now remember that enterprise value is shareholders’ equity (or market capitalization) plus debt less cash, so we need to subtract cash from both sides of the equation:

Short-term debt plus long-term debt less cash and cash equivalents is also known as net debt. So, this gives us:

This is a very important formula. So, when adding net debt to shareholders’ equity or market capitalization, we are backing into the value of the company’s PP&E and working capital in the previous example, or more generally the core operating assets of the business. So, enterprise value is a way of determining the implied value of a company’s core operating assets. Further, enterprise value based on market capitalization, or

is a way to approach the value of the operating assets as determined by the market.

Note that we had simplified the example for illustration. If the company had noncontrolling interests, preferred securities, or other nonoperating liabilities such as unallocated pension funds in addition to debts, the formula would read:

Quite often people wonder why cash needs to be removed from net debt in this equation. This is also a very common investment banking interview question. And, as illustrated here, cash is not considered an operating asset; it is not an asset that will be generating future income for the business (arguably). And so, true value of a company to an investor is the value of just those assets that will continue to produce profit and growth in the future. This is one of the reasons why, in a discounted cash flow (DCF) analysis, we are concerned only about the cash being produced from the operating assets of the business. It is also crucial to understand this core valuation concept, because the definition of an operating asset, or the interpretation of which portions of the company will provide future value, can differ from company to market to industry. Rather than depending on simple formulas, it is important to understand the reason behind them in this rapidly changing environment so you can be equipped with the proper tools to create your own formulas. For example, do Internet businesses rely on PP&E as the core operating assets? If not, would the current enterprise value formula have meaning? How about in emerging markets?

MULTIPLES

Multiples are metrics that compare the value of a business relative to its operations. A company could have a market capitalization value of $100 million, but what does that mean in relation to its operating performance? If that company is producing $10 million in net income, then its value is 10 times the net income it produces; “10x net income” is a market value multiple. These multiples are used to compare the performance of one company to another. So let’s say I wanted to compare this business to another business that also has $100 million in market cap. How would I know which business is the better investment? The market capitalization value itself is arbitrary in this case unless it is compared to the actual performance of the business. So if the other company is producing $5 million in net income, its multiple is 20x; its market...