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May 29, 2014 Articles

Young Lawyer Focus: Enterprise Value as Distinct from Equity Value

In reviewing business valuation reports, it is critical to ask, "What are we valuing?"

By Jeffrey L. Baliban

Business valuation reports can often be confusing not only to the uninitiated reader but to the experienced practitioner as well. It is crucial to understand what, in fact, is being valued and the circumstances under which it is being valued. One should not assume, from the context of the dispute or litigation at hand, that the business or business interest being valued corresponds to the claim allegations at hand. Rather, a good starting point for a valuation is to ascertain whether a business's assets or its equity is the subject of the valuation.

Consider the following valuation description I recently came across in a business valuation report. Can a user of this report readily ascertain what exactly the reported dollar value represents?

The purpose of this evaluation is to determine the estimated fair market value of XYZ Company. The value of the business does not include assets such as cash, accounts receivable, notes receivable, marketable investments, or various portions of inventory, nor does it include certain liabilities such as accounts payable, loans and customer deposits. The evaluator was asked to value the subject company including all assets of the company, both tangible and intangible. However, automobiles, trucks and various machinery and equipment have not been valued. Real estate and improvements have not been valued. Certain intangible assets have been valued even though they are not included on the balance sheet.

Enterprise Value as Distinct from Equity Value

In Valuing a Business, authors Shannon Pratt and Alina Niculita state, "[T]he term 'enterprise value' is used, at best, very ambiguously and, at worst, very carelessly." The Uniform Standards of Professional Appraisal Practice (USPAP) define a business enterprise as "a commercial, industrial, or service organization pursuing an economic activity." However, USPAP does not define enterprise value. Some define enterprise value as the value of a business's assets, differentiating it from equity value, which relates to the portion of those assets owned by equity holders. While this is somewhat helpful, it may be best to go back to defining the value of a going concern as the present value of the stream of economic benefits—typically, cash flows—the entity is expected to generate in the future. To determine whether one is valuing enterprise value or equity value, one has to identify to whom the stream of economic benefits being forecasted will flow.

Invested Capital

Consider that a business can raise capital from two types of stakeholders—debt holders and equity holders—although certain investment instruments have attributes of both debt and equity; e.g., certain types of preferred stock, convertible debt, or bonds with embedded options. (I will leave discussion of these items to another time.) Both debt and equity capital allow the company to acquire funds used to support the purchase of the company's assets. (Recall the basic balance sheet equation Assets = Debt + Equity.) Therefore, invested capital is the combination of both debt and equity capital.

Debt holders lend money to the company. They are those who have invested in the company's debt instruments, such as its banking and credit facilities, revolvers, notes, bonds, or mortgages. A debt holder's return is the principal value of the loan plus interest; typically, a contractual, pre-determined fixed or index-based floating rate of return that ceases once the debt is paid in full. As a result, returns to debt holders are typically much less volatile. The source of funds from which interest is paid must ultimately be from the business's earnings or cash flows; i.e., revenues less all costs and expenses (other than interest expense) incurred to generate those revenues. While the assets acquired with debt funding may be held as collateral, as long as the company complies with the terms of the debt agreement, debt holders do not acquire an ownership interest in the assets. Debt holders have no ownership interest in the business (even though they may have considerable influence in management's decisions) and typically hold no claim on future after-interest profits of the company.

Equity holders, on the other hand, also provide funds to the business but without the business incurring debt. Equity holders, particularly those who purchase common stock, do gain ownership interests in that they acquire the right to vote on corporate issues. Equity holders' returns are from after-tax profits (which are certainly after-interest profits) created by the operation of the business, and after debt principal and interest repayments. This equity return is often paid in the form of dividends issued to shareholders, the increase in the value of the company's shares as a result of profitable operations, or both. Therefore, equity holders do hold claims on the future earnings of the business, although not directly. Because dividends can be paid from cash remaining after the payment of periodic interest expense as well as the current portion of long-term debt, return on equity is riskier (i.e., more volatile) than the return on debt.

Earnings Stream

The overall earnings of a business are really the combined stream of economic benefits available to provide returns to both debt and equity holders; in other words, returns to all invested capital.

Enterprise value is the term often used when determining what is more accurately defined as the market value of invested capital (MVIC); that is, the present value of net cash flows generated by operation of the business’s assets to both debt and equity holders combined. In Introduction to Financial Valuation, James Hitchner defines invested capital net cash flows as those cash flows available to pay out equity holders (in the form of dividends) and debt investors (in the form of principal and interest) after funding operations of the business enterprise and making necessary capital investments. MVIC is most often the focus of valuation in fraudulent transfer investigations. This is because “‘insolvent’ means [a] financial condition such that the sum of [an] entity’s debts is greater than all of such entity’s property, at a fair valuation.” 11 U.S.C. § 101(32)(A)) (emphasis added). The fair valuation of an entity’s property is usually taken to mean the fair market value of the entity’s assets. Because this often means the present value of the stream of future cash flows these assets will generate, the result is the market value of invested capital.

Cash Flow to Invested Capital

Most entities prepare financial statements on the accrual basis. As a result, net income is the difference between revenues earned and expenses incurred. Net cash flow, on the other hand, is the difference between cash collected and paid. Net income is converted to cash flow from operations on the Statement of Cash Flows as shown in this PDF.

Because net income is the residual of revenues less all expenses, and because depreciation and amortization represent noncash expenses (i.e., they do not reflect cash payments in the reporting period), they need to be added back in our effort to determine cash flow. It is also necessary to account for changes in working capital over the reporting period to see how they affect revenues and income. Net working capital is the difference between current assets (assets expected to be turned into cash within one reporting period, usually one year) and current liabilities (liabilities expected to be paid within one reporting period, also usually one year). Determining the change in working capital simply means comparing this year’s balances with last year’s.

In this case, after adding noncash expenses (depreciation and amortization) back to net income, we would deduct the $12,000 increase in working capital to yield cash flow from operations. Why do we deduct this amount? Because the other side of the entry for these accounts flows through the income statement and affects net income. For instance, a $55,000 increase in accounts receivable means that the income statement includes $55,000 of revenue for which cash has not yet been collected (hence, the “receivable”). Therefore, we back this revenue out to get to cash flow. On the other hand, the increase in accounts payable means that the income statement includes $186,000 of expenses that have not yet been paid (hence, the “payable”). Therefore, this gets added back to income to get to cash flow.

Once cash flow from operations has been determined, a few other items must be accounted for to yield cash flow to invested capital, as follows:

Interest expense is the return to debt holders and needs to be added back because it is deducted in determining net income. Because interest expense is tax-deductible, incurring interest expense reduces income taxes paid, so we deduct the tax-affected portion. In other words, if the company pays $100,000 a year in interest expense, taxes paid are $35,000 lower than what they would have been (assuming a 35 percent tax rate). Therefore, the net add-back is $65,000.

Incremental capital expenditures are an important item that is often given short shrift in many discounted cash flow (DCF) analyses. Essentially, these are estimates of cash flow that would have to be invested in maintaining and building property, plant, and equipment, in order to support the cash flow forecasts assumed. It typically relates to research and development, capital spending, acquisitions, and the like. Consequently, it is cash flow that would not be available to debt or equity holders as returns on their investments. One quick way to see if capital expenditure assumptions are reasonable is to look for significant increases or decreases in return on investment.

We now have derived cash flow to invested capital. A DCF that calculates the present value of cash flow to invested capital yields the market value of invested capital (or the enterprise value) of the business. This is the value that then gets compared with the sum of an entity's debts to determine balance-sheet solvency.

Cash Flow to Equity

Equity value is the present value of that portion of the stream of returns remaining after returns to debt holders are paid. I was recently involved in a dissenting shareholder case in which the fair value of a minority shareholder’s stake was the subject of the valuation exercise. One expert used a DCF, discounted at a weighted average cost of capital, to determine the fair market value of the business. He then allocated to the plaintiff her pro rata share of that value. In fact, what the expert determined was the market value of invested capital and not the fair value of the shares.

Cash flow to equity holders requires consideration of a few more items. Building off the previous section, cash flow to equity holders can be determined in an equation shown here.

First, we reverse the interest expense add-back because it represents return to debt holders, which is paid before equity holders can share in returns. Then, we reflect the other portion of returns to debt holders, namely repayment of the debt. This yields cash flow to equity. The present value of expected future cash flows to equity holders yields the current market value of equity.


Although this discussion may seem rudimentary, it is surprising how many times valuation opinions fail because the analyst has valued the wrong security or securities. As I have said previously, a DCF is really two things: a forecast (with an inherent growth rate) and a discount rate. Forecasting the correct cash flows is essential to an appraisal pertinent to the circumstances. Because cash flows are discounted at the cost of capital, a discount rate that is appropriately matched to the cash flows being forecasted is also crucial to reliable results.

Jeffrey L. Baliban – May 29, 2014