Enterprise value vs equity value, explained with a house

“What's the difference between enterprise value and equity value?” comes up in nearly every banking interview. Most people can recite the formula. Fewer can explain it. The follow-ups are designed to find out which group you're in.

The easiest way to really understand it is to forget companies for a moment and think about a house.

The house analogy

You buy a house for $500,000. You put down $100,000 of your own money and borrow $400,000 on a mortgage. What is the house worth? $500,000. What is your stake worth? $100,000.

The house is enterprise value: the value of the whole asset, whoever funded it. Your stake is equity value: what's left for the owner once the lender is repaid. The mortgage is the debt that sits between the two.

Now add a twist. The seller has left $20,000 in a safe and it comes with the house. You'd pay $520,000 for the lot, but the house itself is still worth $500,000. The cash is a separate pile you could use straight away to pay down the mortgage. That's why cash is subtracted when we go from equity value to enterprise value.

The formula, with a fictional company

Enterprise value equals equity value plus debt minus cash. In a fuller version you also add preferred stock and non-controlling interest, since they're claims on the business too. Equity value uses the diluted share count, so options and convertibles in the money are included.

Why EV pairs with EBITDA

This is the follow-up that separates people. A multiple should match its numerator and denominator to the same group of investors.

EBITDA is earned before interest is paid, so it belongs to everyone who funded the business: lenders and shareholders. Enterprise value is also the value to everyone. They match. Net income is what's left after interest, so it belongs only to shareholders. It pairs with equity value, which is why we use P/E and never “EV over net income”.

In house terms: rent you'd earn before paying the mortgage is a return on the whole house. Rent after the mortgage payment is a return on your deposit. Compare each to the right figure.

“A company raises $100m of debt and keeps it as cash. What happens to enterprise value and equity value?”

The classic follow-ups

These all test the same idea. Enterprise value reflects the operating business, so it should only move when the operations change. Trace each one through the formula and you can't go wrong.

1. Raise $100m of debt and hold it as cash: debt rises 100 and cash rises 100, so enterprise value is unchanged. Equity value is unchanged too.
2. Raise $100m of debt to buy back shares: equity value falls by 100 and debt rises by 100, so enterprise value is unchanged.
3. Pay a $50m dividend from cash: in theory equity value falls by 50 and cash falls by 50, so enterprise value is unchanged.
4. Can enterprise value be lower than equity value? Yes, whenever a company holds more cash than debt.
5. Can it be negative? Yes, in rare cases where cash exceeds the market value of equity plus debt. It usually means the market doubts the business itself.