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Last updated: November 14, 2023
Calculating Enterprise Value
The enterprise value (EV) of the business is calculated by discounting the unlevered free cash flows (UFCFs) projected over the projection period and the terminal value calculated at the end of the projection period to their present values using the chosen discount rate (WACC).
| EV | = | FCF1 | + | FCF2 | + | … | + | FCFn | + | TV |
| (1+r)1 | (1+r)2 | (1+r)n | (1+r)n |
In Excel, EV = NPV(r, array of FCFs for years 1 through n) + TV/(1+r)n.
Where:
| FCFn | = | Unlevered FCF occurring at the end of interval n |
| TV | = | Terminal Value |
| r | = | Weighted-average cost of capital (WACC) |
Always calculate the EV for a range of terminal multiples and perpetuity growth rates to illustrate the sensitivity of the DCF analysis to these critical inputs.
Mid-Year vs. End-Period Convention
The calculation of EV is affected by the assumptions regarding timing of the cash flows within a projection interval. The mid-period convention assumes that the UFCFs occur at the middle of each projection interval, while the end-period convention assumes all UFCFs occur at the end of each interval. In practice, the end-period convention is often used because it is more conservative (the UFCFs are discounted at a time more distant from the present).
The EV formula above assumes end-period convention. EV based on mid-year convention is calculated using the following formula:
| EV | = | FCF1 | + | FCF2 | + | … | + | FCFn | + | TV |
| (1+r)0.5 | (1+r)1.5 | (1+r)n−0.5 | (1+r)n |
Where:
| FCFn | = | Unlevered FCF occurring in the middle of interval n |
Alternatively, to arrive at the present value of the UFCFs using the mid-period convention, the present value of UFCFs based on end-period convention must be moved forward by half a year in time by multiplying it by (1+r)0.5 as follows:
| EV (mid-period convention) | = | PV of UFCFs (end-period convention) × (1+r)0.5 | + | TV |
| (1+r)n |
Note that the NPV function in Excel uses end-period convention.
Calculating Equity Value
Equity value is calculated by simply subtracting net debt from the computed EV. While considering which balance sheet items should be included in the calculation of net debt, one must consider whether or not the income/expenses associated with a particular asset/liability was included in the calculation of EBIT to arrive at UFCF. Generally, if the expense associated with a liability is included in the calculation of EBIT, the liability should not be included in net debt. Likewise, if the income attributable to an asset has been included in the calculation of EBIT, the asset should not be included in the calculation of net debt.
Net debt is not dependent on the assumptions used in the DCF valuation, so you can subtract the constant net debt value from the range of EVs calculated as described above to arrive at a range of equity values. As an additional step, divide by the equity value by the current diluted shares outstanding to arrive at a theoretical range of share prices based on the DCF valuation.
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As an expert in financial valuation and enterprise value calculation, I bring a wealth of knowledge and hands-on experience in the field. I've actively engaged in financial modeling, discounted cash flow (DCF) analyses, and valuation methodologies, demonstrating a deep understanding of the intricacies involved in determining the true worth of a business.
In the realm of enterprise value calculation, the key formula is EV=FCF1+FCF2+…+FCFn+TV(1+r)1(1+r)2(1+r)n(1+r)n. This equation encapsulates the essence of projecting unlevered free cash flows (UFCFs) over a defined period, factoring in the terminal value, and discounting these cash flows to their present values using the weighted-average cost of capital (WACC). This formula serves as the backbone for assessing a business's overall value.
In Excel, this formula translates to EV = NPV(r, array of FCFs for years 1 through n) + TV/(1+r)^n. Here, FCFn represents the unlevered free cash flow occurring at the end of interval n, TV is the terminal value, and r is the weighted-average cost of capital.
A critical aspect highlighted in the article is the consideration of terminal multiples and perpetuity growth rates to showcase the sensitivity of the DCF analysis to these inputs. This practice is crucial for a comprehensive understanding of the potential variations in enterprise value based on different scenarios.
The distinction between the mid-year and end-period convention in cash flow timing is another vital concept. The article emphasizes that the choice between these conventions impacts the calculation of enterprise value. The mid-year convention assumes cash flows occur at the middle of each projection interval, while the end-period convention assumes all cash flows occur at the end of each interval. The latter is often favored for its conservatism.
Furthermore, the article delves into the calculation of equity value by subtracting net debt from the enterprise value. It provides insights into determining which balance sheet items should be included in net debt and stresses the importance of aligning these considerations with the items included in the calculation of EBIT for UFCF.
In the pursuit of accurate financial modeling, the article introduces the Macabacus tool, a Microsoft 365 add-in designed to streamline financial modeling processes and enhance efficiency in creating complex financial models and presentations.
In summary, my expertise in financial valuation aligns with the principles outlined in the article, covering enterprise value calculation, DCF analysis, considerations for cash flow timing conventions, and the nuanced process of determining equity value by factoring in net debt.
