Let’s say you have a need to obtain a business valuation and you have a group of advisors offering assistance. One advisor says something about equity value and another says something about invested capital value. Do you know the difference? If you find yourself in a situation in which these terms are tossed around, then you should be aware that there are different ways a company’s capital structure can be measured.
Common valuation terms that relate to a company’s capital structure are equity value, enterprise value and invested capital value. Each value tells a different story and is measured based on different inputs. Being aware of these valuation terms and the ways in which they are calculated will position you to make more informed decisions and hopefully reconcile any differences in value discussed by your advisors.
Equity Value: Is determined based on the number of shares outstanding times the fair value price per share of common stock. Equity value is based on the residual benefit stream of a company after returns have been paid to debt holders (interest and principal).
Invested Capital Value: Is measured based on the market values of a company’s debt and equity. Therefore, it is the sum of a company’s interest-bearing debt, minority interests, preferred equity and common equity. Invested capital value provides an indication of the value of the company as a whole, regardless of how it may be financed.
Enterprise Value: Is calculated based on a company’s equity value (including preferred shares) plus debt and minority interest, minus cash and cash equivalents. In other words, it is the company’s invested capital less its cash and cash equivalents (to determine a company’s operating value separate without regard to how much cash it may have on hand and how it may be financed).
Applying these concepts into an example, let’s use the following balance sheet for the ABC Company. It is important to note that the values used in this example are assumed to be representative of fair value.
Equity Value: Since we already know the values are shown at fair value, the value of common equity is $40,000.
Invested Capital Value: Invested capital value is $125,000, which is the sum of ABC’s short-term credit facility ($5,000), interest-bearing debt ($50,000) (current and long-term portions), minority interest ($10,000), preferred equity ($20,000) and common equity values ($40,000).
Enterprise Value: Enterprise value is $110,000, which is calculated based on ABC’s invested capital value ($125,000) less the value of its cash and cash equivalents ($15,000).
As shown above, depending of the value you are seeking to determine, your results can vary. If you are seeking to value the business as a whole, or to determine the value of all investors (both debt and equity), it makes sense to determine a company’s enterprise or invested capital value. If, however, you want to value of a common shareholders’ interest, then you want to focus on a company’s equity value.
It is critical to understand that these values measure different components of a company’s capital structure, but are interrelated. This is particularly important if a value determined at one level and needs to be reconciled/adjusted to another level. For example, when the market approach is applied, it generally results in an enterprise or invested capital value. Therefore, it is necessary to adjust the resultant value for the debt (and possibly cash) balance of the company as of the valuation date to arrive at an equity value.
As discussed above, there are different measurements of a company’s value. It is important to know the differences of each what each value represents and how the values relate to each other so that an appropriate conclusion of a company’s value can be determined.