• Shivani Deshmukh

Free Step-By-Step Comprehensive Guide to Equity Valuation



If you would learn the rules of the road to building your business on top of it, you will be able to make the right moves at the beginning of your project. Valuing a company means putting an appropriate price tag on it. And that is where Equity Valuation Method can help you – this method if used properly will provide you with a powerful foundation to grow as a business leader.



Valuing a company is not as simple as it sounds. It's not just about coming up with a single number to enter on your financial spreadsheets. That said, it's also not rocket science either. Today we'll walk you through what the equity valuation method is and how you can use it to get an idea of the value of any company for free.



Table of Contents



What is the Equity Valuation Method?



The equity valuation method is a way of determining the value of a company's stock. It uses the market value per share to determine the value of all the shares in a company. This can be useful for investors who want to buy or sell stocks, as well as for companies that want to know their worth when considering mergers or acquisitions.



The equity valuation method considers all the assets owned by a company and then subtracts any debts owed by that company. Then, it divides this number by the total number of shares outstanding - including both common shares and preferred shares - to find out what each share would be worth at current market prices.



Types of Equity Valuation Method



Equity Valuation can be done in 3 types:


  • Balance Sheet Method: This shows how much money the company has in cash and other liquid assets (e.g., stocks). It also shows what kinds of liabilities it has; for example, if someone owes them money then they will show up on their balance sheet as debtors/creditors (also known as accounts payable).


This can be done in 3 ways-



1. Book Value Method:



Defined as the value of all assets less all liabilities.


A common definition for book value is shareholders' equity divided by the number of shares outstanding.





2. Liquidation Value Method



The term "liquidation value" means the amount that could be realized from the sale of all the assets on an orderly basis and in an environment where there are no legal or other impediments to such a sale.



The liquidation value method is based on the scenario in which the company will be sold and liquidated. This method assumes that all assets will be sold off as quickly as possible and at their lowest market prices and the proceeds received would be used to pay off all debts. The remaining balance is then distributed to owners in proportion to their ownership interests.



3. Replacement Cost Method




This method assumes that the buyer would purchase similar assets of similar quality and quantity at the current market value. The replacement cost method calculates the amount of depreciation based on the actual cost to replace the asset at the end of its useful life. It measures the amount needed to replace all inventory lost, regardless of its age or condition.


  • Earning Multiple Method:


1. P/E ratio (price-earnings ratio) - compares a company's share or stock price to its earnings per share (EPS).



There are two types of multiples: LTM (Last Twelve Months) and NTM (Next Twelve Months). The LTM P/E ratio refers to the most recent 12 months' earnings divided by the current share price. The NTM P/E ratio refers to the consensus estimate for the next 12 months' earnings divided by the current share price.




The P/E ratio is perhaps the most popular multiple because it's easy to understand and compare across industries and periods.



For example - if Company A has a stock price of $10 and EPS of $1, its P/E ratio would be 10 (stock price)/1 ($ EPS). The higher this number is above 1, the more expensive the stock is conversely, a low P/E indicates that investors think that shares are undervalued.



2. Price to Book (P/B) Ratio: Price to book value is the ratio of a company's share price to its book value.



Price to book value can vary significantly from industry to industry depending on how profitable companies are and how much cash they have on hand relative to their liabilities. For example, a high price-to-book-v stock in an industry with low profitability may indicate that the market expects more growth in the future than a low price relative to book book-value value in an industry with high profitability.



3. Price to Sales (P/S) Ratio: The price to sales ratio is calculated by dividing the market capitalization by the total sales of 12 months or annual revenue. The higher the number, the more expensive the stock is relative to its peers. The lower the number, the cheaper it is relative to its peers.



The price-to-sales ratio is a great way to compare companies that operate in different industries or sectors. It allows investors to compare companies based on their performance rather than on their growth rates alone.


  • Discounted Cash Flow Method:


It is done in 2 ways-



1. Dividend Discount Method:


Where,


P = Stock price or Value of stock

D = Dividend

r = Required return on common stock (cost of equity) or discount rate

n= number of years

g= Growth rate



The Discount Dividend Model is a financial model used to determine the fair value of a stock. It assumes that a company's value can be determined by calculating the present value of its future dividends. It uses dividends as an estimate for future equity returns. This gives us a discount rate based on our required return and the dividend yield on the stock.



2. Free Cash Flow Method:



Free cash flow is the money that a company generates after paying all its expenses, debts, and taxes. It can be used to pay dividends to shareholders, buy back stock or pay off debt. In other words, it's the cash left over after all the expenses are paid.



FCF is an important metric that investors use to determine whether a company can pay its debts and investments while still making a profit.



FCF is so important because it's a measure of profitability and earning power. The higher a company's FCF, the more likely it is that you'll receive your expected return on investment if you buy its stock.



Net Income + Depreciation (Non-cash expenses) - Capital Expenditures – Increase in Working Capital - Taxes Paid = Free Cash Flow



Formula Used for Equity Valuation Method



Why Equity Valuation is Important?



Equity valuations are performed for many reasons:


  • Buyers and sellers need them as part of their due diligence when negotiating deals.


  • Investors need them when deciding whether to buy shares in a company.


  • Companies need them when they're seeking capital from lenders or other sources who may require certain financial metrics before they will approve funding requests. This information can be used to plan for future growth opportunities and make sound decisions about where you want to allocate resources within your business.


  • Equity valuation is also used by managers to assess the performance of their companies, which in turn helps them make decisions on how to grow their businesses. It helps guide management decisions on whether to issue new shares or buy back existing ones.


  • Book Value Consistency Book values tend to be consistent over time because they are not affected by market conditions. Consumers do not change their buying habits when there was a hurricane last month, nor do they stop eating breakfast because it is cold outside in January. In addition, companies do not change their accounting methods just because they are doing well or poorly at any given time.


Applications of Equity Valuation Method



The equity valuation method can be used for several purposes, including:


  • Valuing publicly traded companies.


  • Valuing privately-held businesses.


  • Determining whether a business is worth more than its net assets (i.e., whether it has goodwill).


Advantages and Disadvantages of Equity Valuation Method



Advantages



There are several advantages of equity valuation:


  • It provides information on how much an investor should be willing to pay for an ownership interest in a company’s stock. This information makes it easier for investors to decide whether they want to buy shares in that company and at what price.


  • It considers all types of assets and liabilities that are listed on the balance sheet.


  • It's easy to understand. Equity valuation uses similar math as other types of financial analysis, so it's easy to grasp the concepts involved.


  • It allows you to make quick estimates of how much money can be raised through an IPO or secondary offering without having extensive knowledge about the company's operations or finances.


Disadvantages


  • It is not 100% accurate. This is because there are always variables that cannot be predicted accurately, such as economic downturns or adverse weather conditions.


  • When an investor seeks to determine the intrinsic value of a stock, he or she must also take into consideration other factors like market conditions and investor sentiment. If these factors change significantly in one direction or another, then so will the value of the stock in question.


  • There is no guarantee that you will be able to sell your shares for their estimated value.


  • Since most companies don't pay dividends, calculating their intrinsic value can be tricky.


Conclusion



The use of equity valuation models has many benefits for both sellers and buyers. These models increase transparency, allowing for a faster transactions. They also make it easier for each party to get a firm understanding of their financial situation in the sale or purchase of a business.



Due to the vast array of factors that affect equity valuation, there are established frameworks to help effectively address important variables. Although it may not guarantee a profitable investment on all occasions it helps identify and manage certain risks, when considered together with other financial information available about the company.



Key Takeaways



Equity valuation is the process of estimating a firm's intrinsic value.
Intrinsic values can be estimated using fundamental analysis using either the book value or earnings approach.
To estimate intrinsic values using the earnings approach, you should forecast free cash flows and discount them at an appropriate cost of capital.


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