Enterprise Value vs. Market Value of Invested Capital

In Small Business Valuations

In a recent joint business valuation review engagement, the author and a fellow appraiser discussed whether one should use market value of invested capital (MVIC) or enterprise value (EV) when applying an income approach in business valuation. In this article, the author discusses these two concepts and sheds some light on why one might use one over the other.

A recent joint business valuation review engagement sparked hours-long discussion between myself and a fellow appraiser about whether we should use market value of invested capital (MVIC) or enterprise value (EV) when applying an income approach in business valuation. In this article, I would like to discuss these two concepts and shed some light on why we might use one over the other.

Definitions

Let’s start with definitions as they are presented in the valuation literature:

MVIC: The market capitalization of equity plus the market value of the debt component of invested capital.[1]

EV: The MVIC, typically adjusted to remove all or a portion of cash and cash equivalents, and other nonoperating assets.[2]

Even though we can see that the difference between MVIC and EV is the cash adjustment, based on these definitions alone, it is not 100% clear what an exact formula for calculating MVIC and EV should be. We need to define things like debt component, invested capital, and nonoperating assets. Let’s take a look at these definitions through the prism of market and income approach.

Market Approach

Under the market approach, there are two primary valuation methods we could employ: a guideline public company method or the comparable transaction method. In both cases, the source of market data should provide us with the definitions of the criteria used to calculate market multiples. For example, if market data presents price to EBITDA multiple and price is defined as EV, we have to follow the definition of EV as it is described by the market data source.

We may have to contemplate the validity of using certain market multiples to value our company, but for the most part, calculation of MVIC or EV under market approach should be straightforward.

Income Approach

To define and understand how we can use MVIC and EV under the income approach, we need to dig deeper into the components of the Gordon Growth model.

Value	=	Stabilized Benefit Stream
		Discount Rate – Stabilized Growth Rate

On the left side of the equation, we have value (e.g., equity, MVIC, or EV) and on the right side, we have the stabilized benefit stream (e.g., net cash flow to equity, net cash flow to invested capital), discount rate, and a stabilized growth rate. All of these elements must maintain consistency with one another.

Ultimately, when using the income approach, we are trying to put value on a certain kind of cash flow. This means that the value will be defined by the type of cash flow we are using. There are two types of cash flows that analysts most commonly use in income approach: net cash flow to equity and net cash flow to invested capital. Let’s dive deeper into each one.

Valuing Net Cash Flow to Equity

Benefit stream: net cash flow to equity

Value definition: market value of equity. Includes all operating assets.

When we are discounting the net cash flow to equity, we use an equity discount rate, usually developed using CAPM or the build-up method. Our cash flow, at least theoretically, will represent cash available to investors that put up equity in the company.

The result of discounting net cash flow to equity will be the market value of equity. In theory, equity value should encompass all business assets necessary to generate our net cash flow to equity. This means that working capital, furniture, equipment, goodwill etc. are all included in the resulting equity value.

Valuing Net Cash Flow to Invested Capital

Benefit stream: net cash flow to invested capital

Value definition: MVIC. Includes all operating assets and interest-bearing debt.

When we are discounting net cash flow to invested capital, we use a discount rate developed using weighted average cost of capital (WACC). Net cash flow to invested capital measures net cash flow available to equity holders as well as cash flow available to creditors that have provided debt capital to the company. Together, these cash flows represent the value of equity and value of invested capital debt.

We usually define invested capital debt as interest-bearing debt because the cash flow to debt originates from interest expense. The MVIC formula so far looks like this:

MVIC = Equity + Interest Bearing Debt

Again, in theory, MVIC should include all operating assets. Additionally, invested capital debt should include interest-bearing debt used in a company’s permanent capital structure. Short term debt, seasonal debt, and related interest expenses should be excluded from the invested capital debt calculation.

Now that we have established what is included in the MVIC, we are ready to compare it to EV.

MVIC vs. EV

Despite both MVIC and EV being calculated using net cash flow to invested capital, they differ in their definition of invested capital.

Using MVIC

MVIC is commonly used in the application of income approach and market approach.

If we choose to use MVIC when discounting net cash flow to invested capital, we are acknowledging that specific assets and liabilities (i.e., invested capital) were utilized to generate this cash flow. Consequently, these assets and liabilities should be included in the MVIC calculation, which encompasses necessary working capital and may or may not include cash.

In order to go from MVIC to equity, we simply need to remove interest-bearing debt, resulting in the following formula:

Equity = MVIC – Interest-Bearing Debt

Using EV

EV is most used in transactions and is usually defined in transaction agreements, such as letters of intent. I seldom see EV being used to develop business value under the income approach. If you arrive at EV instead of MVIC after discounting net cash flow to invested capital, what does this mean?

Per the definition illustrated in the beginning of this article, EV is equal to MVIC less all or a portion of cash or cash equivalents. By integrating the MVIC formula we discussed earlier with the definition for EV, we get the following:

EV = MVIC – Cash

EV = Equity + Interest-Bearing Debt – Cash

If we choose EV as the result of discounting net cash flow to invested capital, we are implying that cash (either all or a portion of it) is not necessary to generate the net cash flow to invested capital, as cash is not part of EV. Essentially, we are saying that cash is a non-operating asset and, hence, should be added back to equity.

Equity = EV – Interest bearing Debt + Cash

Conclusion

At its core, the key distinction between MVIC and EV is the treatment of cash. Under MVIC, if cash is part of working capital, then cash is treated as an operating asset and is included under the value of equity. Under EV, cash (all or a portion of it) is non-saleable or non-transferrable and is excluded from the value of equity.

In my practice, I focus on valuations of small healthcare businesses, comprising mostly of surgery centers, medical, dental, optometry, and podiatry practices. When it comes to discounting net cash flow to invested capital, my preferred method is to calculate the MVIC. Once I have arrived at the MVIC, I then make the necessary adjustments to determine the value of equity. I do this for a couple reasons:

1. It is hard for me to envision the owners of the small businesses I value being able to operate, or feel comfortable operating, their businesses with zero cash in the bank. I am sure there are exceptions out there. One such exception could be a primary care practice that derives a significant portion of its revenue from capitation payments. If the capitation payments are substantial and received consistently, the business might be able to operate optimally with minimal or no cash reserves.
2. It seems logical to use MVIC and take care of any non-operating cash in the normalization adjustments section of the report. If I determine that the business holds excess cash, my approach would be to first normalize the cash balance to reach the optimal level of working capital. After calculating the value of equity, I would then add the excess cash, along with any other non-operating assets, to the equity value.

Ultimately, as valuation analysts we should employ our experience and professional judgment in selecting MVIC or EV. We also have to stay consistent with our decision through the rest of our analysis. 

I welcome your thoughts!

[1] The International Glossary of Business Valuation Terms (June 08, 2001).

[2] The International Valuation Glossary—Business Valuation (November 2021), jointly published by the American Society of Appraisers, the CBV Institute, the Royal Institution of Chartered Surveyors, and the Saudi Authority for Accredited Valuers.

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Alexey Nechay is the president of Nechay Appraisals, where he focuses on helping healthcare professionals navigate practice transitions, divorces, and litigation matters. He maintains certifications as both a Certified Valuation Analyst (CVA) from NACVA and a Certified Healthcare Business Consultant (CHBC) from NSCHBC. He currently serves as president of the American Society of Appraisers Los Angeles Chapter.

Mr. Nechay can be contacted at (855) 955-2565 or by e-mail to an@nechayappraisals.com.