performance of the company or produce a value of the underlying operations of the company. If the objective is to produce a valuation, then the calculation will use the most up-to-date (market-based) values for capital. If the objective is to calculate capital to analyse the historic operational performance of the business (using ratio analysis such as DuPont analysis), then the accounting version of enterprise value, which is called capital employed, needs to be calculated. Capital employed is based purely on the accounts of the business being valued and is also known as book value.
When looking at a company, an analyst will often find that the company has set of core activities (and associated capital) that generate what would be termed operating returns. These are the underlying, ongoing and sustainable returns of the company. These activities will be detailed in the historic accounts of the company and will usually be split out into some form of divisional analysis. For example, in Nestlé’s financial statements, the activities of the business are split between the three core geographic regions of its food business (Europe, America and Asia), the Nestlé Waters business and the Nestlé Nutrition business. However, companies will often have made investments in areas outside of their core activities (“non-core assets”) that must also be reported in their financial statements. In Nestlé’s case, it has a 29.4% investment in L’Oréal SA, which is not part of the core activities of the company and would be stripped out of any valuation of the core operating activities.
Calculating Capital for Ratio Analysis – Capital Employed
Total capital employed of the company can be calculated in two different ways:
These two ways of calculating total capital employed must balance (as they are derived from the two sides of a balance sheet). However, as a set of accounts has been used to calculate capital employed, this may also include non-core assets and liabilities and, as we mentioned above, should not be included in our calculation of operating capital. Therefore, to calculate operating capital employed, net non-core assets must be deducted from the calculations above as follows:
Again, the two approaches to calculating capital employed in this way, being accounting based, will balance, providing a useful cross-check.
Calculating Capital to Value a CompanyThe accounting-based method of calculating capital is used to analyse performance, but it is a historic measure. It cannot be used to calculate the current market value of a company’s capital, which will be required for a market-based valuation. The calculation of capital for valuation purposes therefore uses market values for the equity and non-equity financing (fair value of debt, pensions, etc. and market value of equity) to come up with a value for equity or enterprise capital used by the company. However, this approach can only calculate the liability side of the balance sheet, as there is not enough information in a set of accounts to calculate the market value of operational assets, even with the greater fair value disclosure for assets and liabilities under IFRS.
The calculation of enterprise and equity capital can be summarised as follows:
If it is assumed that the market is valuing the business correctly, then the share price of the company will include a value for any non-core assets of the business. To arrive at the underlying value of the operating assets of the company (operating enterprise and equity value), the net non-core assets must be deducted as follows:
Unfortunately, as the valuations above can only be determined from the liability side of the balance sheet, this means it is impossible to cross-check an enterprise value from an asset and liability approach. If it was possible to value each of the operating assets separately, then the difference between book value of assets and enterprise value from a liability perspective would be the market’s view of the fair value of the operating assets. This would reflect things like intangible assets that are not reflected in the accounts, views on the recoverability of receivables, etc.
Going back to the BG Bridge, this shows how the non-core assets are incorporated into a valuation if market values are used. If market values are used in a valuation, then (assuming the market correctly values the company and all its assets and liabilities) the enterprise value and equity value calculated are total enterprise and equity values. Deducting non-core assets produces a valuation for operating enterprise and equity values. Operating enterprise and equity values are sometimes called “clean” values. They represent only the core operations of the company being valued and are often a better source for comparison across industry sectors. The reason why the distinction between total and operating values is important is that certain valuation approaches will produce an operating enterprise or equity value (for example a discounted cash flow or dividend discount valuation). As discussed above, if the valuation approach produces an operating enterprise or equity value, then the non-core assets must be added to the operating valuation to arrive at a total enterprise or total equity value. A total equity value should, if the market is valuing the company correctly, be equal to the current share price and any difference would be an arbitrage opportunity. These two approaches to valuation are called a relative valuation if the approach starts with a market (total) value, or an absolute valuation approach if an operating enterprise/equity value is produced (subsequently adjusted for any non-core assets). The two approaches are discussed in more detail later.
Key learning points:
- Different calculations of capital are required for analysis and valuation purposes.
- Capital employed is required for analysis purposes and enterprise value and equity value for valuation purposes.
- Depending on the valuation approach used, the capital value calculated will either be a total (including non-core assets) or an operating (excluding noncore assets) value.