When people talk about "investing" in a company, it's common to think in terms of buying equity -- a piece of ownership, usually by purchasing shares of stock. But lending money to a company represents investment, too. The concepts of "invested capital" and "enterprise value" take into account all outside investment in a company, as both equity and debt.
Whether you own equity in a company (stock) or hold debt in that company (in the form of bonds or notes), you're an investor. You expect a return for your money, and that return must be sufficient to compensate you for the risk you bear. "Invested capital" represents the total amount of money currently invested in a business, regardless of the source. Invested capital is important when determining whether a company is making what the finance industry calls an "economic profit" -- profit beyond the return required by investors as the cost of using their money. This differs from the more familiar "accounting profit," which is just a company's revenue minus its expenses.
Invested Capital Elements
There are different ways to calculate invested capital using information from a company's balance sheet, but all should produce the same general result. Aswath Damodaran, a finance professor at New York University's Stern School of Business, offers this simple definition: Invested Capital = Fixed Assets + Current Assets - Current Liabilities - Cash. It starts with fixed and current assets because the value of a company's assets always equals its equity plus its liabilities (that is, its debts). The equation then subtracts current liabilities -- obligations that must be paid in the near future. Finally, it subtracts the cash balance. The reason for this: Cash that's sitting in a bank account or in a short-term investment (which is where companies keep much of their cash) isn't actually invested in the company itself.
Enterprise value represents the value of a company's ongoing business. It's perhaps best thought of as the "takeover value" -- what it would really cost you to buy the company. It's different from the traditional measure of company value, market capitalization. Market cap tells you how much it would cost to buy up all of a company's outstanding shares, which would make you that company's owner. But if you own the company, then you're responsible for paying all of its debt. So the amount of debt the company is carrying has to factor into the value. Further, if you buy a company, any cash the company has sitting around becomes yours, too, so that has to be accounted for.
Enterprise Value Elements
In their textbook "Corporate Finance: The Core," Jonathan Berk and Peter DeMarzo provide a simple formula: Enterprise Value = Market Value of Equity + Debt - Cash. Market value of equity consists not only of market capitalization (the market value of all common stock) but also the value of any preferred shares the company may have issued. Debt includes all of the financial obligations of the firm. Put together, these two elements make up the combined value of equity investors' and debt investors' stake in the company. The cash balance then gets subtracted out, since this would effectively be a "rebate" to a buyer.
Video of the Day
- New York University Stern School of Business: Return on Capital (ROC), Return on Invested Capital (ROIC) and Return on Equity (ROE) - Measurement and Implications
- "Corporate Finance: The Core," Second Edition; Jonathan Berk and Peter DeMarzo
- ReadyRatios: Enterprise Value