Googling does not seem to provide a conclusive answer to this with a justification. I get that in a general sense, market values are preferred to book values because they represent more of a “real” sense of what equity is worth, but at the same time, the book value of equity is how much capital has actually been invested in a business. It’s what the company is actually working with.
Background : My reason for asking this is I’m trying to find the WACC to discount cash flows for a private company using data from publicly-traded comparable companies.
Yes and no. If you see some revaluation accounts inside total equity on the Balance Sheet, then your statement is incorrect. Real life example: The company owns since 2015 an industrial building that was bought at 10 million and accounted for such a value in BS, however, in 2020, management decided to reflect the market value of the building being 20 million. Book value of the building is adjusted to 20 million and equity part of BS will show a revaluation account for 10 million. At this moment, the book value of equity is not equal to the capital that has been actually been invested in the business in money terms. Part money, part mark-up.
In strict terms, the book value of equity is indeed the “capital invested” because the company can sell the property for 20 million now but decided to “reinvest” the “proceeds” (gains) into the business.
Ok, no more discussion, lol.
The recommended construction for D/E ratio in WACC calculation is using the D/E resulting from the projected / desired capital structure of the company. Most of the time, it is an arbitrary ratio.
If you want to calculate D/E ratio from current capital structure for valuation purposes, then use market value of debt and market value of equity in case of analyzing public companies.
Thanks, I’ve found that there is not a significant difference between the D/E ratios yielded from using BV and MV of equity for this particular sample. Theoretically though, I suppose if you’re interested in the fair value of a security you would use market value anyway. Interestingly, if the difference is significant, the lower debt to equity ratio found using market values will wight equity more heavily in the projected capital structure, causing your subject company to have a higher cost of capital. I find this to be somewhat counterintuitive, since if the market is rewarding companies in the industry with higher valuations relative to their book values, your subject will be penalized in a sense. Which might be an argument in favor of book value, but that’s just tangential musing.