when stock price goes up, so does EV and shareholder's equity, but what happens to asset side of equation?
I'm from a non-finance background, and recently started learning accounting/valuations...this may sound like a stupid question, but if assets = liabilities + shareholder's equity, and lets say the stock price of a firm skyrockets for some reason, then EV will also skyrocket, and the right hand side of the equation will increase...but there has not been any real change in the assets of the firm right? I mean just because the stock price goes up does not mean the company gets more cash or any other type of asset...am I missing something here? how does the asset side of the equation account for a sudden increase in the price of the stock (or bonds)
stock price doesn't change shareholder's equity in the equation. stocks are traded on secondary markets. shareholder's equity is simply what the shareholders would get once the company's assets are liquidated and creditors paid. basically whats left
You're confusing equity value with shareholders' equity. Equity Value = Market capitalization = Share price * common shares outstanding. Shareholders' equity is, for a simple firm, the amount of capital contributed to the firm, i.e. [# of shares ever issued] * [price at which issued] less any shares bought back and the price at which they were bought back (in simple terms). There's also the retained earnings component, which has nothing to do with shares or prices of shares.
Above is not clear and probably a little confusing to you.
Think of it this way... shareholders' equity is fixed, and will only change if there are additional equity issuances/share buybacks. We call this "book value of equity." Book value is what is used in the A=L+E calculation and is what is reported on the balance sheet.
Market value of equity is what you're thinking of. As share price increases, market cap increases, and vice versa. But this does not effect the A=L+E equation.
read jims
Ok, so shareholder's equity stays fixed when stock price skyrockets, although market cap and EV go up...but let's say someone wants to acquire the company, they have to then pay EV (which includes market cap), NOT just shareholder's equity right?
for example, let's say a company as Assets = 20, liabilities = 10, and SE = 10, with 10 shares outstanding (issued at $1)....now lets say share price goes up to $5, so market cap = 5*10 = 50, and debt = 10, therefore EV = 60, and someone has to pay 60 to acquire a firm with assets of only 20? what am i missing in this picture? (assume company has no cash)
I do not think you are missing the picture, just not making the links.
They would pay more because there is the potential for growth and positive earnings (the going concern principle), it really all depends on how much cash flow the firm is generating.
You may want to look into "market/book" ratios which will almost always show a company selling at more than its book value (denoted by a ratio greater than 1). Pretty much all stocks sell at higher prices than what their book value per share is because of the going concern principle and expected earnings.
Also read about DCF (Discounted Cash Flow), it will help you see how a firm is valued and why it may sell for $60 in an acquisition when it only has $20 in assets, etc.
OP you're trying to compare apples and oranges here. Think about the purpose of a balance sheet: it lists the things the company uses to make money (assets) and how it paid for those things (liabilities & se). So when a company initially issues the stock it brings in cash (asset) which is offset by the increase in the SE. However once that stock has been issued by the company, nothing else will change on the balance sheet. If I sell you 10000 shares of Home Depot stock that I own, does Home Depot get any more money as a result of the transaction between you and I? No.
Equity Value and Enterprise Value are market-based numbers that indicate what the perceived value of the company is. Think about it in terms of buying or selling a house. The price a realtor advertises the house for can be though of as equity value. Enterprise Value includes things you need to pay for aside from the cash you give to the seller. Maybe the house has a leaky roof that needs to be fixed. Fixing that roof adds to the total cost you pay to acquire the house. Conversely it might come with appliances and furniture, lessening the grand total cost of acquiring the house.
Think about Shareholder's Equity kind of like what it cost me to build the house in the first place (assume I'm selling it to you). It could have cost me a lot of money if I hired a construction team and bought materials from a lumber yard. But let's just say that I'm an awesome carpenter and I chopped down the trees myself and build the thing by myself to all the same standards, thereby saving myself lots of money. But in the end, if I want to sell my house, it doesn't really matter to you, the buyer, what I paid for it in the first place. I could have won the thing in a bet and paid nothing for it.
This is a really good explanation. Thank you.
So, why exactly is EBITA used in valuations?
EBITDA is used because when comparing companies you want to look at the value the company is generating from a capital structure neutral perspective; how much value the business itself is generating. Say you have two different companies with identical factories. One factory was financed with debt, the other with equity. The company that financed the factory with debt has interest payments that will affect Net Income, whereas the other company does not. But they are generating the same value. By using EBITDA (or variants thereof depending on the industry) you eliminate those differences, and you get closer to comparing apples to apples.
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