DCF - Circular References in Calculating Implied Share Price
Hello,
can someone help me clarify how the problem of circular references is solved when determining the implied share price in a DCF? I do know how to adjust Excel so that the calculation can be solved, but still don't understand how the initial issue of fully diluted shares outstanding being dependent on the implied share price has been overcome by this. I still need to know how to determine if an option/warrant or security is in-the-money, which is based on the implied share price which in turn is based on fully diluted...
Implied Share Price = Implied Equity Value / Fully Diluted Shares Outstanding
It sounds like you already know how to set up the circular calculation in Excel. Conceptually, what will ultimately trigger an increase in your shares outstanding count is total equity value. The larger the equity value (driven by your assumptions around growth, profitability, etc.), the more likely warrants and options become ITM and therefore could increase shares O/S. In summary, shares outstanding won’t drive the total equity value calculation. There is an inflection point in total equity value such that the price per fully diluted share will either have value or it wouldn’t.
My apologies, but it still isn't clear to me. Again, for determining fully diluted shares I have to assess if outstanding options/warrants are in-the-money. For this I have to compare their strike price with the implied share price, which in turn..
Would you be good enough and give it one more try? To me it sounds like a chicken or the egg dilemma.
Forget share prices for a minute and think about why options or warrants are issued in the first place. They are meant to enhance returns for an investor IF the total equity value grows beyond a certain tipping point. This tipping point when divided by the pro forma fully diluted share count would be the strike price.
Let's say a company's equity value today is $1mm and there are 1mm shares, so $1/common share. Let's say you lend this company some money and in exchange they have to pay you back the face value of that loan (plus interest) and also issued you warrants that may convert to 100k common shares if the fully diluted 1.1mm shares have a price/share of $2. This means the equity value has to grow from $1mm today to $2.2mm before the warrant expiration date in order for those warrants to be convertible to shares. If equity value grows to $2mm, then guess what, those warrants are worthless. Point being, the aggregate equity value is not a function of how many shares there are. Warrants / options could drive share count (the denominator in share price) but will not drive equity value (the numerator in share price).
Many thanks for the explanation!
Just to make sure that I understood correctly - to calculate the implied share price you take the implied equity value and divde it by the amount of basic shares outstanding and whatever result you get is used for deciding if an option/warrant is in-the-money or not. By this you determine the assumed number of fully diluted shares and use it to derive the implied share price?
I added a picture on of an example from my textbook. Here for instance it would be taking the equity value of $4,500mm and divide it by 80mm basic shares, leading to a share price of $56.25. Using this - options 1, 2, 3 would be in the money and thus converted, giving you additional net new shares of 1.818mm, fully diluted of 81.818mm and eventually an implied share price of $55.
Hope this is correct.
The only edit I'd add is you are not dividing equity value by the basic shares o/s (80,000 in your txtbook) but rather the fully diluted shares o/s (81,818 in your txt book) when calculating the implied share price of $55.00, which is the the price against which the strike prices of those options are measured when determining if they're ITM or OTM. The exercisability of the shares associated with those options was probably what confused you around circularity. Just remember that total equity value ($4,500 in the txtbook), which is the numerator in your price/share calculation, is not dependent on share count.
I just don't get where the $55 is coming from. Don't I need to have that value before I decide if options/warrants are in-the-money or not?
No you do not.... Your txtbook laid it out very clearly for you. It's the $4.5bn of equity value (whose calculation is very clearly not tied to anything relating to share count, as illustrated) divided by the 81.8mm of shares and there's a whole bridge that gets you to that share figure.
I feel like you're asking the same question all over again... which I've answered as clearly as I could have and even laid out a simplified example. You are still thinking about share price as the driver when you should be thinking about the total equity value as the driver. The share price is really the output that you use to infer what the equity value and diluted share counts are. Maybe someone else can take a stab at explaining. I've done the best I could.
Turn on iterative calculations
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