Equity Value, MVIC, and Enterprise Value

What do they mean and how they are measured?

Much confusion can be avoided by clearly defining the level of value utilized in a business appraisal. The terms equity value, enterprise value (EV) and market value of invested capital (MVIC) are often bantered with no clear delineation between them. This article delineates between these levels of value and discusses the ways in which they can be measured. The importance of understand these terms, and which level of value has been measured in an appraisal, is important to comply with statutory demands and to avoid the double-counting or mis-counting of assets/liabilities in a business transaction. 

Overview and Definitions

Each level of value has its own specific application. Enterprise value tends to be the focus in the sale of a business. Equity value tends to be the focus in the sale/transfer of a fractional interest within a business. Market value of invested capital is typically used as a starting point to derive an equity level of value. 

With this in mind, let’s take a look at some definitions in the International Glossary of Business Valuation Terms.

Equity Value. Equity value is measured as the difference between the market value of assets and the market value of total liabilities. As a formula:

Equity Value = Assets – Liabilities

Market Value of Invested Capital (MVIC). The market capitalization of equity plus the market value of the debt component of invested capital.  As a formula:

MVIC = Equity + Interest-Bearing Debt

Enterprise Value (EV). The MVIC, typically adjusted to remove all or a portion of cash and cash equivalents, and other nonoperating assets. As a formula:

Enterprise Value = MVIC – Cash and Equivalents – Non-Operating Assets

Equity Value and Market Value of Invested Capital

Equity value is the most common level of value considered, as it applies to tax valuations (e.g., estate and gift) and buy-outs of fractional interests within a company. At the end of the day, equity value is the best measure of a business owner’s stake in an entity.  

Equity value considers all aspects of a business’ balance sheet, as it is calculated as total assets less total liabilities. No asset nor liability can be ignored in calculating equity value. This demands consideration of non-operating assets (e.g., notes receivable, marketable securities, real estate, contingent/off-balance sheet assets, etc., as the case may be) and non-operating liabilities. 

The difference between MVIC and equity value is simply the Company’s operating interest-bearing debt balance. Thus, these two levels of value are intimately related and are discussed concurrently. 

Implications for the Income Approach: Equity versus Invested Capital Level Cash Flows

The income approach offers the most nuance with regard to equity value. While the cost approach (e.g., the Net Asset Value Method) is a straightforward way to ascertain an equity value, the income approach entails many nuances that could lead an appraiser astray. 

The income approach is based on an expectation of future cash flows adjusted for the risks inherent in obtaining those cash flows. The risk is measured by either a discount rate or a capitalization rate, depending upon the methodology utilized. In either case, the underlying mathematics are inextricably linked (i.e., if an appraiser utilizes the same set of assumptions in a Discounted Cash Flow methodology as in a Capitalization of Earnings Methodology, the concluded value will be the same).  

The rule is this: The level of value produced in an income approach is determined by the nature of the cash flows discounted/capitalized. If control level cash flows to invested capital are utilized, the value return will be the market value of invested capital.

That cash flow controls the level of value has not always been the case. Until the early 2000s, many appraisers assumed that an income approach will always produce an equity value on a minority, marketable basis. This is because the risk rate is based on equity returns on publicly traded stocks. Eric Nash was critical of this point, and his position that there is little distinction between these values in public stocks has largely been accepted. 

To clarify the distinction between these two, it is helpful to define equity cash flow versus invested capital cash flow. 

Equity Cash Flow. Equity cash flow is the cash flow that is available to an equity investor in an enterprise, after satisfaction of all operating costs, debt obligations, capital expenditures, and financing activities. 

Invested Capital Cash Flow. Invested capital cash flow is the cash flow available to the stakeholders in the company’s capital structure. This includes equity financiers and debt lenders. 

The American Society of Appraisers (ASA) shows the difference between these two as such:

*Net Operating Profit After Tax, which is net income plus interest expense.

The two major differences in the above are: (1) invested capital is calculated before an interest expense, and therefore reflects a debt-free cash flow; and (2) equity cash flows account for the principal payments on debt. 

The capitalization of an equity level of cash flow will provide an equity indication of value, and likewise for invested capital cash flows.

Income Approach: Relationship Between Cash Flows and Risk Rates

It is imperative that the risk rate match the cash flow base. Only an equity risk rate should be applied to an equity level of cash flow, and only an invested capital risk rate should be applied to invested capital cash flows.

In either case, the risk rate is usually determined by either the Modified CAPM or the “Build-Up” method. As it applies to equity risk rates, such rate will only consider the risk of an equity investment, and will ignore the debt component of an enterprise’s capital structure. 

Meanwhile, the “Weighted Average Cost of Capital” (WACC) applies to invested capital cash flows. The WACC is calculated as the weighted average of the various components of an entity’s capital structure. This usually includes common stock and interest-bearing debt, but would also include preferred stock if applicable. 

An example of the difference between these two risk rates is below.

Income Approach: An Example Based on the Above Information

To round out our discussion on the income approach, let’s calculate the value of this fictitious entity using the cash flows and risk rates ascertained above:

Presented in this fashion, one can see the significant variance between the two levels of value, both of which are presented on a control, marketable basis of value. The invested capital value can be converted to an equity value by subtracting long-term, interest-bearing debt. In theory, and indeed in practice, the value should come reasonably close to the equity value. 

Enterprise Value

While it is theoretically possible to conduct a valuation that arrives at an enterprise level of value, it is not recommended. To derive an enterprise value, the best approach is to first derive a MVIC value and then adjust for cash and cash equivalents. With the above definitions and discussion, the math should be intuitive at this point. 

Enterprise value is rarely relevant in a tax setting or in the buy-out/buy-in of a fractional interest. These are perhaps the most common reasons for a valuation engagement. It is highly relevant from a sale perspective, as it is often the basis of value in a letter of intent (LOI), and it is then adjusted, usually respecting working capital, to derive a final deal price. 

Conclusion

It is my hope that the distinction between these three levels of value is clearer now, as is the methods to arrive at them. MVIC and equity value are the most common and important in business valuation. Enterprise value usually comes into play with mergers/acquisitions, but it is not a value directly derived using a traditional valuation methodologies. 

Perhaps most important is understanding that equity value is a component of market value of invested capital, and the difference is measured by the market value of the interest-bearing debt carried by an entity.