Hey guys,
I'm currently working on an EVA valuation and I noticed that the book value of invested capital is one of the components of the valuation.
Why is it that book value is used here instead of market value? I always thought book values didn't matter in valuation and you don't include them in a DCF.
Would be of great help if you could shine some light on this matter.
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According to the EVA valutation, or the Residual Income (equity side), the value of a given asset depends on its book value + the return that this company is able to generate in excess to its cost of capital.
If the company is able to generate a positive economic profit (where ROCE > WACC) you will have EV > BV. If the company is not able to meet its cost of capital (ROCE WACC) you will have that its EV BV.
So, the model assumes that the value of a specific assets depend on its "standard" return, which is reflected by its Book Value, and the value of its excess returns ((ROCE - WACC)BV). Therefore, EV = BV + BV(ROCE - WACC).
At the same time, if the company does not meet its required return, its market value is lower than its book value since BV*(ROCE-WACC) will be negative for ROCE WACC.
If you were using the Market Value you would have: EV = EV + EV(ROCE - WACC) and it does not make any sense because you will arrive to a solution where EV is equal to something (EV + EV(ROCE-WACC)) that (for ROCE > WACC) cannot, by definition, be equal to EV.
To sum up, these valutation methodologies use the BV to estimate the Market Value.
Thanks, you helped me alot!
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