If you have been on the receiving end of one of our business valuation reports, you may have seen an appendix containing the International Glossary of Business Valuation terms. Several business valuation organizations developed this Glossary: ASA (American Society of Appraisers), AICPA (American Institute of Certified Public Accountants), CBV Institute (Canadian Institute of Chartered Business Valuators), NACVA (National Association of Certified Valuators and Analysts, and IBA (The Institute of Business Appraisers).

In this article, I would like to highlight four key definitions and how certain cash flows are calculated.

Equity—the owner’s interest in property after deduction of all liabilities.

Equity Net Cash Flows—those cash flows available to pay out to equity holders (in the form of dividends) after funding operations of the business enterprise, making necessary capital investments, and increasing or decreasing debt financing.

Invested Capital—the sum of equity and debt in a business enterprise. Debt is typically (a) all interest-bearing debt or (b) long-term, interest-bearing debt. When the term is used, it should be supplemented by a specific definition in the given valuation context.

Invested Capital Net Cash Flows—those cash flows available to pay out to equity holders (in the form of dividends) and debt investors (in the form of principal and interest) after funding operations of the business enterprise and making necessary capital investments.

Conclusions of value are developed from two types of cash flow:  Equity Net Cash Flows and Invested Capital Net Cash Flows. The difference is best seen in an actual example. This example is from an article written more than 20 years ago that I still refer to today. [1]

Click here for Figures 1, 2 and 3

The main difference between the two cash flow streams is debt and interest. For Invested Capital Net Cash Flows, there is a return to debt holders in the form of interest. In this case, it is $60 after tax (Figure 2).  As the business receives a tax savings on the interest expense, the full amount of interest expense is not added back. 

Using the same set of numbers, the equity holders still have to pay interest expense (and it is not added back to income) however, they could receive an increase in long term debt, which is a cash inflow, or pay back debt which is a decrease to cash flow.

How Does This Impact Valuation?

In arriving at a conclusion of value, the valuation analyst must match the selected cash flow, either Equity Net Cash Flows or Invested Capital Net Cash Flows to the proper rate of return. A typical business valuation error is mismatching of cash flow streams and rates of return.

Invested Capital Net Cash Flows must be matched to the Weighted Average Cost of Capital ("WACC").  WACC is a rate of return that is used for invested capital and is a rate of return based on the Cost of Equity and the Cost of Debt, weighted by the percentage of equity to total invested capital and debt to total invested capital (formula), respectively.

Equity Net Cash Flows must be matched to a rate of return appropriate for an equity investment. This rate of return is the Cost of Equity. The Cost of Equity differs from WACC in that the Cost of Equity only considers equity components in the rate, and doesn’t consider Cost of Debt or percentage of debt (to total invested capital).The WACC is usually lower than the Cost of Equity since the Cost of Debt is typically lower than the Cost of Equity, and there is a tax savings attributable to the Cost of Debt (that doesn’t apply to the cost of equity).  

If the valuation analyst does not correctly compute either of the two cash flow streams and/or does not accurately match it to the appropriate rate of return, there will be an understatement or overstatement of the conclusion of value. We will continue this discussion as “Part 2”, next month.


[1] “The 12 Commandments of Business Valuation”, as prepared by Frank C. Evans, American Business Appraisers, Sharon PA 16146. Frank is also Co-author of Valuation for M&A: Building Value in Private Companies, by David M. Bishop and Frank C. Evans (John Wiley & Sons Inc., 2001).