DCF Value and Enterprise Value

The process/formula to obtain the Instrinsic Value (IV) of a firm using Discounted Cash Flow (DCF) is very similar to the process for calculating a firm's Enterprise Value (EV). I had wanted to see the logical link between these two values.

To summarize and simplify, let FV = value of the firm due to the discounted future free cash flows. Then we have IV = FV + Cash – Debt. By definition from the formula, IV = money you get from liquidating the company.

In the case of calculating EV, we have EV = Market Value (MV) – Cash + Debt. By definition again, EV = money you need to use to buy the company and clear all debts.

Re-arranging the IV formula, we have FV = IV – Cash + Debt. At this point, the equation of FV and EV looks very similar.

Now, note that if say MV < IV, then theoretically we can buy the company (keeping the debt) using MV, and liquidate the company to receive IV, and make the spread. Hence it is clear that MV should be compared with IV.

On the other hand, EV should be compared with FV, and not IV. Note that when MV = IV, then EV = FV. Why should the Enterprise Value be equal to the discounted future free cash flow value? Because, if you were to move in and buy a company using EV, this will settle the debt and the cash, i.e the "current capital structure and excess cash part" is settled, so what you have effectively paid for (i.e. what is left behind), is purely the future cash flows of the business (unleveraged), i.e. FV.


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