So far, we have talked about the net earnings used in applying the Gordon Model (and the DCF model) and have inferred that there are other concepts of earnings. The formulation we discussed develops indications of the equity value of a business, while we also noted that there is a concept of value related to total capital.

It is now time to look at different levels of earnings on an income statement and understand how they relate to each other and how they convert to indications of value. The two types of value are:

• Market Value of Equity (MVE). MVE is the value of all of the shares (or member interests or partnership interests) held by the owners of a closely held business – or a public company for that matter. Ultimately, this is the value that matters for business owners. This is an estimate of what your business is worth in the market to you.
• Market Value of Total Capital (MVTC). MVTC represents the sum of the MVE, or equity value of a business, and all of the debt owed by the business to banks or other lenders. Lenders are stakeholders, too, and their needs (interest on their loans and timely repayment of principal) are important to them and to any business. This kind of value is important because it represents the way that many market participants, i.e., those who buy companies, look at value. MVTC is one step on the way to MVE. MVE equals MVTC minus Debt.

Market Value of Equity

To begin to understand these concepts, let’s make the following assumptions about a hypothetical company:

• Sales equal $10 million
• Net income (after taxes) is $1 million
• Market Value of Equity is $10 million
• There is $2 million of debt on the balance sheet at an interest rate of 5%
• Market Value of Total Capital is $12 million (i.e., MVE of $10 million plus debt of $2 million)

We previously mentioned two equity-based earnings concepts, net cash flow and net earnings (or net income). There is one more. And there are earnings measures that relate to the total capital of a business. We examine the equity-based measures in the first table below.

In the example, we begin with net cash flow of $850 thousand. A portion of net income ($150 thousand) will be reinvested in the business. We know that the MVE is $10 million, so the net cash flow multiple is 11.8x ($10 million divided by $850 thousand).

We are focused on equity values and equity multiples here. Since value is the same, the multiples change as we move up the income statement to broader measures of earnings. The price/earnings multiple for net income is 10.0x and the multiple for pre-tax earnings is 6.0x. We look at this progression up the income statement and the change in multiples for an important reason:

It is important to apply the right multiples to the appropriate and corresponding measures of earnings. This is a key reason why business owners are sometimes confused regarding value. The information they hear about transactional multiples may not match the concept of earnings they have in mind.

In the example, we infer equity valuation multiples from the given equity value.

We also show the total capital values, which are derived by adding the $2 million of debt to the equity value of $10 million, and total capital multiples.

Market Value of Total Capital

The next table continues to move up the income statement all the way to sales. The multiples are calculated based on the Market Value of Total Capital, i.e., the sum of that provided by equity holders and the debt capital provided by lenders. In the table, equity values are derived by subtracting debt from MVTC.

We calculated pre-tax income in the previous table and begin with it now. The company has $100 thousand of interest expense based on $2 million of debt at a 5% rate. We add interest expense to pre-tax income to get what is called EBIT, or Earnings Before Interest and Taxes.

We know that the Market Value of Total Capital is $12 million, so the implied multiple of EBIT is 6.8x. The multiple is derived my dividing MVTC of $12 million by EBIT of $1.767 million.

The last total capital earnings multiple is that for EBITDA, which is derived by adding depreciation of $233 thousand to yield EBITDA of $2 million. The implied EBITDA multiple is therefore 6.0x ($12 million divided by $2 million).

Finally, we see the implied multiple of sales of 1.20x, which is the result of dividing MVTC of $12 million by $10 million in sales.

These total capital results raise another important point that sometimes causes confusion for business owners when they think about valuation.

The total capital multiples provide indications of the Market Value of Total Capital, and not the Market Value of Equity. In order to get to the value of what a business owner’s equity investment, it is first necessary to subtract the debt to get to the Market Value of Equity. It should be clear that MVE and MVTC are two different concepts.

This point may seem obvious, but I have seen business owners and their presumably sophisticated advisers miss the point in a few buy-sell agreements – leading to potentially devastating results for one side or the other following a trigger event.

Until next time,

Chris