Enterprise Value (EV) is a crucial financial metric used in valuation to determine the total value of a company, taking into account both its equity and debt. It represents the theoretical price an acquirer would have to pay to take over the entire business. When computing Enterprise Value, we add Minority Interest to the equation to ensure a comprehensive valuation that reflects the company's true worth.
Minority Interest refers to the ownership stake in a subsidiary that is not wholly owned by the parent company. In other words, it represents the portion of the subsidiary's equity that is held by external investors, and the parent company owns less than 100% of the subsidiary's outstanding shares. When a company consolidates its financial statements, it combines the financials of its wholly-owned subsidiaries, but it also accounts for the Minority Interest separately.
The reason behind adding Minority Interest to Enterprise Value is to give a more accurate representation of the total value of the business. The concept can be better understood with the help of an example:
Example: Let's consider Company ABC, which owns 80% of XYZ Inc. XYZ Inc. is a subsidiary that operates independently, and the remaining 20% of its shares are owned by external investors (Minority Interest).
Suppose we want to calculate the Enterprise Value of Company ABC. We first need to determine the equity value, which is the market value of the company's outstanding shares. Then, we add the debt and subtract cash and cash equivalents to arrive at Enterprise Value.
Calculate Equity Value:
Assume that the market capitalization (outstanding shares x share price) of Company ABC is $500 million.
Determine Minority Interest:
To find Minority Interest, we multiply the percentage of ownership (in decimal form) by the total value of the subsidiary.
Minority Interest = 0.20 (20% ownership) x (Value of XYZ Inc.)
Calculate Enterprise Value:
Enterprise Value = Equity Value + Total Debt - Cash and Cash Equivalents + Minority Interest
Now, let's say the total value of XYZ Inc. is $200 million.
Minority Interest = 0.20 x $200 million = $40 million
Enterprise Value = $500 million (Equity Value) + $100 million (Total Debt) - $50 million (Cash and Cash Equivalents) + $40 million (Minority Interest)
Enterprise Value = $590 million
By adding Minority Interest, we account for the value of the portion of XYZ Inc. that is not directly owned by Company ABC. This is essential because, in a real-world scenario, an acquirer looking to purchase Company ABC would need to consider the entirety of XYZ Inc., including the minority stake. Ignoring Minority Interest in the valuation would result in an incomplete and inaccurate representation of the company's total value.
In summary, adding Minority Interest to Enterprise Value ensures a more comprehensive valuation, capturing the true worth of the business by accounting for the portion of subsidiary ownership not held by the parent company. It allows investors, analysts, and potential acquirers to make more informed decisions regarding the overall value and potential of the company.