When valuing an enterprise, the measure of earnings you will consider to estimate cash flows is operating income. By doing so, you will not be valuing any of the assets or liabilities whose earnings/(expenses) are not part of the operating income. These include cash and marketable securities, debt and debt-like items, and surplus assets, which you will either add to or subtract from the Enterprise Value ("EV") to arrive at your Equity value.
Adjusting value estimates can be very confusing, so we hope to make it easier for you today. If you need a refresher on how to perform an asset-side valuation, you can read our articles on DCF, Trading Multiples and Transaction Multiples.
Enterprise Value to Equity value
To calculate Equity value from EV, add non-operating assets and subtract financial liabilities, as follows:
Equity value = EV + Cash & Marketable Securities + Surplus Assets/(Liabilities) + + Minority Interest + Majority Holdings - Financial Debt - Debt-like Items
Cash & Marketable Securities
Interest income from these assets appears below the operating income line. You have to add the value of unrestricted cash and marketable securities to your operating asset value.
Surplus Assets & Liabilities
The gains/(losses), or revaluations/(write-offs) deriving from deviating market and book values of non-operating assets and liabilities appear below the operating income line. Value adjustments may include:
changes in the market value of land and real estate investments, generally supported by third-party documentation (i.e. appraisal reports), and
contingent liabilities and unprovided amounts that are generally identified during a due diligence, such as unprovided tax exposures, unprovided credit exposures (i.e. additional loan book provisions), unamortised debt issue costs, and unaccrued legal costs.
Income from minority shareholdings held in other companies is rarely included within operating income. Value each shareholding on a stand-alone basis, apply the equity stake held in each by the company you are valuing, and add the pro-rata values to your operating asset value.
These will be 100% consolidated in your financials. In this case, you should first estimate the EV of the parent company, by stripping the income, assets and liabilities related to the consolidated holdings from your financials. Then, value each shareholding on a stand-alone basis, apply the equity stake held in each by the parent company, and add the pro-rata values to the operating asset value of the parent company.
If, for whatever reason, this exercise were impossible to perform (e.g. for lack of data), you could estimate the consolidated EV and subtract the portion of equity that the parent company does not hold in the majority shareholding (i.e. non-controlling interest, or NCI). However, this may yield misleading results, as stated by Prof. Aswath Damodaran: "if you have not valued the subsidiary separately, it is not clear how you would do this. Note that the conventional practice of netting out the minority interest does not accomplish this, because minority interest reflects book rather than market value" (source).
You will typically net this off against your unrestricted cash balance to calculate net debt. Financial debt typically includes:
market value of bank loans and borrowings, estimated based on current market rates (you may consider the book value if contractual interest rates are in line with current market rates), and
shareholder loans that pay interest, have a repayment plan and a maturity date.
These are non-operating liabilities that the company will need to pay in the future and, as such, resemble debt. They typically include:
Provision for end of service benefits ("EOSB"),
Related party loans, and
Deferred tax liabilities ("DTL").
We hope you found this article useful. For questions or clarifications, feel free to reach out. Thanks for reading, and good luck!