In this post we will discuss four important and interrelated concepts of value. We have talked about Market Value of Total Capital and Market Value of Equity in previous posts. It is now time to develop a clear understanding of what each of these terms means. We will also introduce a new term, Enterprise Value. We will also distinguish between the Market Value of Equity on an operating basis and the total value of equity of a business.
Let’s talk about these terms conceptually. We will then examine their components in the context of a diagram that should clarify their similarities and differences.
- Market Value of Total Capital (MVTC). MVTC includes the market value of equity on an operating basis, the market value of debt, and any cash on the balance of a business being valued. It would also include cash and any other excess working capital. For purposes of this discussion, assume that any other non-operating assets are separately excluded from consideration.
- Enterprise Value. Enterprise Value is MVTC, as defined above, less cash. Stated alternatively, Enterprise Value is the sum of Market Value of Equity (operating basis) plus the market value of debt, where book value of the debt is typically used as a proxy for market value.
- Market Value of Equity (Operating). The market value of equity on an operating basis is Enterprise Value less debt. MVE (Operating) represents the value of equity of a business before considering cash and any other non-operating or excess assets.
- Total Value of Equity. The Total Value of Equity for a business is the sum of MVE (Operating) and cash.
These four valuation concepts can be seen in the three right-most columns in the chart below.
The chart is placed here for perspective and without further discussion. We examine the components of the chart in detail below. I’ll refer to them as Items 1 through 18 as we continue.
The Book Value Balance Sheet and the Market Value Balance Sheet
In this section, we discuss the book value balance sheet and the market value balance sheet. We will, in a non-accounting, non-technical way, examine the manner in which the market value balance sheet is created as result of an appraisal or a transaction, giving evidence of the value of all of the business assets. We focus on the left portion of the larger chart above.
Item 1: Book Value Balance Sheet
The book value balance sheet is the balance sheet as prepared by your accounting firm. It reflects the balance sheet on an historical cost basis. All assets and liabilities are shown at their historical costs, with the exception of depreciable or amortizable assets, which are shown at their historical costs net of depreciation or amortization applicable to them.
For example, assume that a building was purchased for $2 million a decade ago. To make the math simple, assume that the building is being amortized over a period of 20 years, or at the rate of $100 thousand per year. The historical cost balance sheet will reflect the building at its depreciated value of $1 million, even though the building may have appreciated considerably in value over the period of ownership.
Further, on the book value balance sheet, there are no entries to reflect the creation of any goodwill or intangible assets resulting from the operation of a business. That is because, under Generally Accepted Accounting Principles (GAAP), it is not appropriate to create assets for which no price was directly paid.
Item 2: Book Value of Equity
The book value of equity reflects shareholders’ equity based on the historical costs, net of accumulated depreciation and amortization. Book value of equity is the so-called “book value” that many business owners and market participants refer to when they look at a balance sheet.
Item 3: Book Value of Debt
The book value of debt is the total outstanding debt on the balance sheet. Sometimes debt is categorized as short-term when it is due in one year or less. If debt matures after one year, it is typically categorized as long-term in nature. For our purposes, all debt, whether short-term or long-term, is included in the book value of debt. There are exceptions to this, but we will go with the general rule.
For valuation purposes, unless there is a specific reason to investigate its value, the book value of debt is usually considered as a proxy for the market value of debt. So when we talk about debt, we are usually referring to its book value and its market value synonymously.
Item 4: Cash Asset
We focus specifically on the cash asset because it has clear value and can be used to repay debt. We will examine the relationship of cash, debt and value as we proceed.
Item 5: Market Value Balance Sheet
We now look at what is called the market value balance sheet. To look at the market value balance sheet, we have to assume that a valuation of the business has been conducted or that a transaction has occurred that established the “market value” of the business and all of its assets. With a market value balance sheet, inventories and accounts receivable and other working capital items are generally considered at their book values, unless there is reason for a different treatment. We will see that the write-up from the book value balance sheet to the market value balance sheet involves looking at assets in three categories, or buckets.
Item 6: Fixed Asset Write-up
To create the market value balance sheet we need to calculate or estimate the value of all assets. For example, the $1 million net book value of the building we discussed in Item 1 would be adjusted to the current market value of the building, which may be, for example, $3 million. On the chart at Item 6 there is an arrow moving upward. What that means is that the historical book values of fixed assets are “written up” to their current market values.
Item 7: Intangible Assets
When companies are purchased, under GAAP, a “purchase price allocation” must be performed to allocate the total purchase price appropriately to all assets acquired. For example, trademarks and other “identifiable” intangible assets must be separately valued and placed on the balance sheet. They may then be amortized over periods reflective of their estimated lives.
Item 8: Goodwill
When value (from a transaction or an appraisal) has been allocated to all assets tangible and identifiable intangible assets and there is additional purchase price left, the remainder is said to represent goodwill, which is an unidentified intangible asset.
Item 9: Market Value Added (MVA)
The write-ups in moving from the book value balance sheet to the market value balance sheet are in three primary buckets, as we have seen: the write-up of fixed assets, the allocation to identifiable intangible assets, with the remainder going into the goodwill bucket.
For illustration purposes, we’ve added those three buckets to the liability side of the market value balance sheet at the top so we can visually see the effect of the write-up of assets on the liability side. The sum of goodwill, intangible assets and the fixed asset write-up is labeled Market Value Added (MVA). In reality, MVA is a part of the operating equity value of a business, which we will see momentarily.
We see that the market value balance sheet considers the value of all of a company’s assets, whether tangible or intangible, at their market (or appraised) values. The market value balance sheet is the beginning point for developing the four valuation concepts we noted at the beginning of this post.
In the next post, we will move from the market value balance sheet to develop MVTC, Enterprise Value, Market Value of Equity (Operating), and Total Value of Equity. We do this on a conceptual basis because this will help as we begin to discuss specific measures of earnings, like net income or EBITDA, in the context of valuation.
In the meantime, be well!