This is Part 1 of a four part series that will serve as a valuation primer. The purpose of Part 1 is to give an overview of common terms and methods used to value an equity interest in a company.
The issue we are trying to resolve when valuing a business is the price that two independent parties would pay for or be willing to receive for the interest they hold. The value of a business interest depends on the future benefits that will accrue to it. The financial benefits from ownership must come from one of the following sources: distribution of earnings, from the sale of the interest, or distribution from the liquidation of assets. In determining the value of a business interest, one should focus on the benefits the shareholder(s)/member(s) may receive from long-term ownership in the securities. In appraisal terminology, these three sources of return correspond to the income, market, and adjusted net asset value approaches, respectively.
When using each of the three approaches, the valuation analyst must also keep in mind the size of the interest being valued and the underlying financial information used to determine the value. This series of four valuation primers will cover the levels of valuation and the approaches to value.
Minority Interests and Controlling Interests
The value of a shareholder’s interest in the stock of a company is influenced by the shareholder’s access to and ability to distribute cash. In general, an ownership interest greater than 50% is considered a controlling interest and an ownership interest less than 50% is considered a minority interest. The type of interest being appraised (control or minority) will influence the underlying choice fundamentals on which the valuation is based and the approaches used in the valuation.
If the assignment is to value a minority interest, the underlying financial information used should reflect those to which a minority interest holder generally has access. On the other hand, when valuing a controlling interest, the financial information used should reflect those to which a controlling interest holder has access. , or those available only to a controlling interest holder. For example, if we are valuing a minority interest in a company that holds assets worth $1 million, the minority interest holder most likely cannot force the company to sell those assets or distribute those assets. A controlling interest holder can adjust financial structure, control dividends/distributions with regards to timing and amount, alter operating efficiencies, set compensation amounts, hire and fire employees, etc. A minority interest holder has no ability to control any of these issues, and they have influence on these issues only at the discretion of the controlling interest holder(s).
A minority interest fair market valuation based on a control basis will need to be adjusted for the loss of value represented by the lack of control associated with a minority interest holder. This adjustment in value is called the minority interest discount or the discount for lack of control. It is applied only to arrive at a minority interest fair market value when the base value was derived from controlling interest assumptions and analyses.
Equity, Invested Capital and Enterprise Value
The level of control in a company will also impact the methodology we use to determine the value of an interest. If we are valuing a minority interest, we may choose methodologies that directly value the equity that is the subject of the valuation. But, if we are valuing a controlling interest, we may use calculations that produce the value of the company as a whole. Ultimately, we are looking to arrive at an equity value and there are typically three ways to do so.
The first way to determine the equity value is to use approaches and methods that produce an equity value directly. These approaches and methods are discussed in Part 2, Part 3 and Part 4 of this series.
Another way to determine the equity value is to value what is referred to as total invested capital (TIC). Total invested capital is also sometimes referred to as market value of invested capital (MVIC). TIC or MVIC is defined as equity plus debt. Therefore, to determine the equity value from an invested capital value, we simply subtract debt. This method is typically used when we are valuing a company with debt.
Finally, a third method to calculate the equity value is to determine total enterprise value (TEV). Total enterprise value is defined as equity plus debt, minus cash. Therefore, to determine the equity value from a total enterprise value, we subtract debt from the total enterprise value and add cash. Depending on the facts and circumstances of the valuation, total enterprise value is sometimes modified to include net working capital (current assets less current liabilities) instead of cash.
The interest being valued will determine the overall methodology selected by the valuation analyst. Whether the interest has control or is a minority interest will impact the initial choices made by the valuation analyst and is the foundation of the rest of the analysis. In Part 2, we will discuss the Asset Approach, one of the three approaches to determine the value of an equity interest.
Jason Bolt leads the Business Valuation Team at Jones & Roth. He is an active writer and speaker on specialized business valuation topics.