Value of Cash Conveying in an M&A Transaction
I’ve been asked the following question on several occasions:
If a publicly traded company is being acquired and it has cash in the bank, would the acquirer need to pay more to include the value of the cash?
It’s kind of a technical question, and the answer is somewhat unintuitive initially, but fairly straight forward once explained with a simple analogy.
The calculation for Enterprise Value (EV) – the actual value of the company – subtracts cash.
EV = (market cap) + (debt) + (minority interest) + (preferred shares) – (cash and cash equivalents)
If this seems backwards, keep reading.
Let me use an analogy that makes this more relatable.
Let’s say you are buying a house for $500,000. The market value (equivalent to EV) is $500,000 (this is the market value by definition, since this is what you are willing to pay).
The current owner has a $200,000 mortgage (debt) and therefore $300,000 in equity (market cap). We’ll assume that the mortgage debt transfers to you as the new owner.
$500,000 (EV) = $300,000 (market cap) + $200,000 (debt)
With a simple purchase of a home, there are no minority interests, no preferred shares and no cash left lying around in the house (at least not with any house I have purchased).
In this example, you assume the $200,000 mortgage and pay $300,000 in cash for the house.
Now suppose, in an unusual circumstance, the seller says he wants $510,000 for the house because he’s going to leave $10,000 in cash on the kitchen table. That’s fine with you because you’ll pay $310,000 in cash ($10,000 extra) but you’ll get $10,000 in cash from the seller, so it nets out.
For the purposes of this example, we’ll ignore the potential problems of receiving $10k in cash, like potential mortgage fraud and dubious origins of the cash.
In this case, you’ll still assume the $200,000 in mortgage debt, but you’ll pay the seller $310,000 at closing. So, it’s a wash (pun intended)… simply trading dollars-for-dollars.
The equation for enterprise value:
EV = equity + debt – cash
…now looks like this: $500,000 (EV) = $310,000 (cash) + $200,000 (debt) – $10,000 (cash from seller)
The debt doesn’t change, but notice that the equity went up to account for the cash left in the house.
So even if the seller leaves $10,000 cash in the house, the value of the house itself does not change.
The cash left on the kitchen table is the same concept as a company leaving cash in the bank for the buyer. The buyer accepts it, but the value of the equity should already account for any excess cash conveying with the business as part of the acquisition.
I hope this analogy brings this concept closer to home (again, pun intended).
Real Life Examples
Real-life examples of this occur when public companies carry vast amounts of cash on their balance sheets (think Apple). When the level of cash exceeds the normal working capital needs of the business, the value of the equity goes up to account for the excess cash. Even for companies that are not performing well, if they have excessive cash on hand, the equity will trade higher simply for the value of the cash. Because the equation for EV subtracts the cash, having the excess cash does not change the enterprise value… but it does influence the value of the equity.
So, enterprise value does not include the value of the cash… except that which might be tied up in working capital… but that’s another conversation, discussed in more detail in an earlier blog post: