The Portable MBA in Finance and Accounting, 3rd Edition

Business Valuation 605

intention to liquidate the assets. In addition, this approach does not clearly re-
f lect the value of the business resulting from its earnings potential.

Debt-Free Analysis

She further explains to Bob that there are two ways to value the equity (stock)
of a private business under the income approach. The first is the direct equity
methodology.Under this approach a company’s net income or cash f low is the
basis to determine the value of the company’s stock. This methodology either
capitalizes net income or net cash f low, or it determines the present value of a
series of future cash f lows.
The second is the debt-free methodology(or invested capital methodol-
ogy). How much or how little a company is leveraged can have a significant im-
pact on the value of the company’s stock. If a specific company has too little
leverage or too much leverage as compared to an ideal blend of debt and equity
capital, the direct equity methodology may result in a distorted valuation.
A company’sinvested capitalrepresents all of its sources of capital to
fund the business—capital from investors (equity) and lenders (debt). When
we say the value of a “business,” it often has a different meaning from the
value of the corporation’s equity. This concept is illustrated below.

When we say the value of a “business” or “company,” we are often refer-
ring to the value of the overall capital (the debt and equity capital equals the
total assets). Many sales transactions are structured only to transfer the assets
of a business and it is up to the buyer to raise capital from investors and /or
lenders. (In an asset sale, the seller would be responsible for paying off the ex-
isting debt, usually upon the receipt of the sales proceeds.) When the objective
is to value only the equity, debt is subtracted from the value of the total assets.
This is the underlying model of the debt-free methodology. First, the total as-
sets are valued based on the company’s cash f low without regard to servicing
the debt. Second, if the equity is being valued, then the company’s debt is sub-
tracted from the value of the assets.
The direct equity methodology determines the value of the equity by
using the net cash f low af terthe company services its debt, which results in a

=

Value of assets

Value of

overall capital structure

Debt

Equity