The Daily Technical #136: How do you calculate equity value from enterprise value?

Good evening. Welcome to the 136th edition of The Daily Technical.

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OVERVIEW OF YESTERDAY’S QUESTION
What is an illiquidity discount?

The illiquidity discount used when valuing private companies is related to being unable to exit an investment quickly.

Most investors will pay a premium for an otherwise similar asset if there's the optionality to sell their investment in the market at their discretion.

Therefore, a discount should be applied when performing trading comps since shares in a public company include a premium for being sold in the public markets with ease (called the "liquidity premium").

Common Mistakes

1. Confusing Illiquidity with Insolvency. Illiquidity refers to the difficulty in selling an asset quickly, whereas insolvency involves a company's inability to meet debt obligations. Clarify that the illiquidity discount specifically addresses the challenge of quickly exiting an investment, not the financial health of the company.

2. Assuming the illiquidity discount is fixed regardless of market context. Realize that market conditions can influence liquidity, and evaluating factors like market volatility and investor sentiment is crucial when determining the appropriate discount.

3. Overlooking how the illiquidity discount impacts trading comparables can lead to faulty valuations. Remember, when comparing private and public companies, account for the liquidity premium embedded in public company valuations to avoid overestimating the value of private shares.
   

TL;DR

• Illiquidity Discount: Results from difficulty in swiftly exiting a private company investment.

• Liquidity Premium: Public company shares carry a premium due to easy market sale options.

• Investor Preference: Investors favor assets with easy sale options, often paying a premium for liquidity.

• Trading Comps Adjustment: Apply discounts on private company shares to reflect absence of liquidity premium.

TODAY’S QUESTION
How do you calculate equity value from enterprise value?

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