(an excerpt from Skoda Minotti’s “How a Company is Valued” eBook)
Investors in publicly-traded companies have the luxury of knowing the value of their investment at virtually any time. An internet connection and a few clicks of a mouse are all its takes to get an up-to-date stock quote. Of all U.S. companies, however, less than 1% are publicly-traded, meaning that the vast majority of companies are privately-held. Investors in privately-held companies do not have such a readily available value for their ownership interests. How are values of privately-held businesses determined, then? Each month, this eight blog series will answer that question by examining a key component of how ownership interests in privately-held companies are valued.
Levels of Value
All values are not created equal – for example a company’s “equity value” can be vastly different than its “enterprise value.” Therefore, before beginning any valuation analysis, it is important to establish what type of value is being determined.
Common valuation terms that relate to a company’s capital structure are equity value, enterprise value and invested capital value, each of which are discussed in greater detail below:
Equity Value – Equity value is the value of a company allocable to its equity investors. Equity value is the most commonly-determined value as it represents the value of an investor’s ownership interest in a company.
Invested Capital Value – Invested capital value represents the combined value of a company’s interest-bearing debt and equity. Invested capital value provides an indication of the value of the company as a whole, regardless of how it may be financed. A/P, accrued expenses and other non-debt liabilities are typically not considered part of “interest-bearing debt” for the adjustment from equity value to invested capital value (and vice versa) because these liabilities are part of a company’s net working capital, not its equity/debt capital structure.
Enterprise Value – Enterprise value is calculated based on the following formula:
Enterprise Value = Equity Value + Debt – Cash
Stated differently, enterprise value is equal to the company’s invested capital less its cash. Enterprise value is often used when determining EBITDA and revenue-based multiples because it removes the impact of how much cash a company is carrying (which is simply a financing decision) in determining the value of its operations.
The figure below provides a visual reconciliation between equity value and enterprise value:
It is critical to understand that these values measure different components of a company’s capital structure, but that they are interrelated. This is particularly important if a value is determined at one level and needs to be reconciled/adjusted to another level. For example, when the market approach is applied, it oftentimes results in an enterprise or invested capital value. Therefore, it is necessary to adjust the resultant value for the interest-bearing debt (and possibly cash) of the company being valued to arrive at its equity value. While EBITDA multiples are often thrown around in conversation, it is important to note that the value determined when applying an EBITDA multiple is generally an enterprise value, so confusing this with an equity value may result in an investor significantly overestimating the value of his or her ownership interest (particularly for companies with meaningful debt balances).
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