Equity Valuation

Equity valuation refers to the approach and methodology applied to determine the intrinsic value of the shareholders equity in a company. Intrinsic value is the true value of a company based on its fundamentals such as its growth rate, management quality, strategic advantage and other tangible and intangible factors. Shareholders equity (or equity) represents the stake of shareholders in a company. It includes the initial investment, cumulative retained earnings and cumulative other comprehensive income of the company among other things.

Book value of equity equals total assets of the company minus its total liabilities. This fundamental relationship is represented by the accounting equation. In case of listed equity (i.e. stock of companies which are listed on a public stock exchange), market value is readily available. Total market value of all outstanding common stock of the company is referred to as market capitalization and it equals current market price per share multiplied by total number of outstanding shares of common stock.

Intrinsic value is different from market value. While market value represents the value assigned to the company by market forces, intrinsic value is a value that ought to prevail when all investors consider all the information related to the company’s business.

Equity valuation models can be broadly categorized into (a) relative valuation and (b) absolute valuation. In relative valuation, a stock’s value is determined in relation to market value of comparable stocks. Under this approach, we determine price multiples (such as price to earnings ratio (P/E ratio), price to book ratio, price to sales ratio, etc.) of comparable companies and multiply it with expected earnings, book value and/or sales of the company under valuation.

Models

Under the absolute valuation approach, there are two methods to value equity: (a) determining the total firm value based on free cash flows and subtracting the market value of its debt, in which case the cash flows are discounted using the cost of capital, and (b) determining the value of equity directly by discounting the free cash flows to equity using the cost of equity of the company.

In absolute valuation, value is determined by discounting future cash flows under different models, i.e. single-stage dividend discount model, multi-stage dividend discount model, free cash flows based model, etc. The choice of model depends on whether the equity stake under consideration is a majority holding (>50%) or a minority stake, certainty with which cash flows can be forecasted, the growth stage of the company and whether the stock is listed on an exchange or not.

Formula

Under the dividend discount valuation model, value of a company’s stock is arrived at using the following formula:

Value of a Share =Dividend per Share Next Year
Required Return on Equity – Dividend Growth Rate

Value of Equity = Value per Share × Number of Common Shares Outstanding

In multi-stage dividend discount model, different level of dividend per share is expected in different periods, each of which is independently discounted.

Dividend discount models are appropriate valuation approaches in valuing a minority stage in the company.

In case of majority holding, value of a company is best determined by discounting the free cash flows to firm (FCF) or free cash flows to equity (FCFE) using the cost of capital as follows:

Value of a Company =Free Cash Flows to Firm Next Year
Cost of Capital – Growth Rate of FCF

Value of Equity = Value of Company – Market Value of Debt

Value of equity can be determined directly using the following formula:

Value of Equity =Free Cash Flows to Equity
Required Rate of Return on Equity – Growth Rate of FCFE

Written by Obaidullah Jan, ACA, CFAhire me at