Equity Valuation

What Is Equity Valuation?

Equity Valuation is the method used to find the Value of a company's equity.

First, let's examine the two key components: equity and valuation. Equity represents the ownership interest in an entity, like a company. Valuation is the process of calculating securities or a company's worth.

Equity valuation is the worth of a company's equity. It can be calculated in various ways. Professionals use techniques such as market value, DCF, CCA, and precedent transactions to calculate equity value.

Hedge funds, investment banks, and individual investors all use equity valuation. The motivations include M&A deals, investment decisions, strategic planning, and more.

It is important to note that equity valuation does not account for a company's debt, which may make it difficult to calculate its entire value.

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Equity Value accounts for the Value of ownership in a company, whereas enterprise value is the Value of a company's debt and equity.
Equity valuation is used by Investment Banks, Hedge Funds, Private Equity Firms, Asset Management Firms, Corporations, Individuals, and academic researchers.
The main equity valuation methods are market cap, discounted cash flow, comparable company analysis, and precedent transactions.
Precedent Transaction gives the highest Value, followed by DCF, then CCA, and Market Cap has the lowest valuation.

Who uses equity valuation?

Equity Valuation is used by individual investors and large financial institutions. The key reason is for investment decisions. It helps determine whether an asset is overvalued or undervalued.

Equity valuation is used by:

Investment Banks: Several departments within investment banks use equity valuation. The two main ones are the equity research and investment banking departments. Equity research analysts research companies to provide clients with insights on whether to buy, hold, or sell publicly traded companies. Investment banks use valuation to buy, sell, and take companies public.
Private Equity Firms: Use Equity valuation to determine whether target companies are good investments. This helps determine a target company's financial health, growth potential, and price to buy.
Asset management Firms: Firms like mutual funds, pension funds, and equity funds use equity research reports to assess risk, investment opportunities, and management portfolios.
Hedge Funds: Use equity valuation to identify securities that are inaccurately priced, predict market trends, and exploit other inefficiencies to give higher returns to investors.
Individual Investors: Many individual investors use equity valuation to make strategic investments for themselves.
Corporate Finance Departments: Corporate finance departments use equity valuation to assess their stock, competitors, and the overall market.
Academic Research: Professors and other academic researchers help further develop equity valuation models through research, studies, and the development of new models.

Equity Valuation methods

Knowing how to use each of the main equity valuations is essential for any career in finance. Financial professionals, from investment bankers to corporate finance analysts, will use the following methods:

Market Cap

This is perhaps the easiest method to calculate and understand. It is calculated by multiplying shares outstanding by the company's current stock price.

When calculating market cap, assume warrants, convertible securities, and options in the money are exercised. This gives a larger amount.

Let's look at a real-world example of market cap. As of March 21st, 2024, Apple's stock price was $171.60, and 15,509,763,000 shares were outstanding. Let's calculate it below:

$171.60(Stock Price) x 15,509,763,000 (shares outstanding)=$2.65 Trillion(Market Cap)

Companies Market Cap is a great resource for checking a company's market capitalization without calculating it by hand.

The major limitation of using a market cap to value a company's equity is that it applies only to publicly traded companies.

Discounted Cash Flow

Discounted cash flow is the most commonly respected valuation method bankers use. It relies on the idea of the time value or money value of a company or security.

There are four major steps to discounted cash flow: projecting out free cash flow, estimating free cash flow beyond year 5, using WACC as the discount rate, and discounting back to year zero.

Step 1—Projecting out free cash flow: When calculating a DCF,

companies project free cash flow, usually five or ten years into the future.

Free Cash Flow is calculated using the formula:

Free Cash Flow = Net Income + Depreciation/Amortization – Change in Working Capital – Capital Expenditure

Step 2—The terminal value: The terminal Value is the Value after the projected period of future free cash flows. Two common ways to calculate it are the perpetuity approach and the Exit Multiple approach.

Exit Multiple approach is calculated using the formula:

Terminal Value = Final Year EBITDA x Exit Multiple

The exit multiple can be any valuation, such as EV/EBITDA. The Perpetuity Method is calculated through the use of the formula:

Terminal Value = (Final Year FCF x (1 + Perpetuity Growth))/ (Discount Rate - Perpetuity Growth)

The perpetuity growth rate is usually between 2 to 5% between the inflation rate and GDP growth.

In Step 3—WAAC is used as the discount rate to discount future free cash flows to the present. This is based on the idea of the time value of money, which means money today is worth more than the same amount of money tomorrow.

WACC is often chosen as the discount rate since it encompasses the risk used for a new company. The WACC formula is:

WACC = E/ (D + E) * (r_e) + E/ (D + E) * (r_d) * (1 - t)

E = Market Value of Equity
D = Market Value of Debt
re = Cost of Equity
rd = Cost of Deb
t = Corporate Tax Rate

Step 4—Discount back to year zero: The last step is to put all the pieces together and discount to year zero(the present). The formula to use is:

PV = FCF₁/ (1 + WACC)¹+ FCF₂/ (1 + WACC)² + …. + FCF_n/ (1 + WACC)ⁿ + Terminal Value/ (1 + WACC)^x

If the present Value of the discounted cash flows is more than the current Value, the asset is usually undervalued.

Some of the drawbacks of DCF Valuations are:

Relies heavily on assumptions
Sensitive to change in parameters
Estimating terminal Value is subjective
Ignores trends in other industries

Comparable Company Analysis

Comparable company analysis is a valuation method that bases a company's Value on that of its peers. It can calculate equity value and enterprise value. Completing a comparable company analysis requires five steps.

The four steps of comparable company analysis are choosing comparison companies, choosing key financial metrics, calculating metrics and multiples for all companies, and evaluating the company.

1. Choosing Comparison Companies

When selecting comparable companies, it is essential to base them on size, geographic location, and industry. A good way to start doing this is by looking at competitors in the company.

The number of companies to compare should be between 5 and 10. Anything less than 5 could be considered too small, and anything more than 10 could make the process too complicated.

2. Choosing key metrics and multiples

The main idea behind CCA is that similar companies should have similar multiples. This helps to tell if your company is overvalued or undervalued. Common multiples used when doing CCA are listed below.

P/E Ratio (Market Price Per share/Earnings per share)
EV/EBITDA Ratio (Enterprise Value/Earnings before Interest tax depreciation amortization)
P/B ratio (Market Cap/Book Value)
EV/Sales (Enterprise values/ revenue)

Typically, these multiples should be calculated for the previous 12 months and projections for the next two months. It is good to use between three and five multiples covering revenue and profitability. It is important to note that different industries may use industry-specific multiples.

3. Calculate the multiples and metrics

After deciding on the metrics and multiples to be used, it is time to calculate them. The first step is to calculate the company's equity or enterprise value based on share price, outstanding shares, and balance sheet information.

Next, the key metrics from the financial statements will be gathered to gain historical numbers from the previous 12 months.

Once all data is gathered, calculate the multiples for each company at each period. Calculating margins and growth rates is also important when building a model.

4. Determine the Valuation

It is important to determine the companies using mean, median, and different percentiles. Then, multiply the company's applicable figures by each multiple. This should give a range of what the company's Value should look like.

Precedent transactions

Precedent Transactions is a valuation method used only for mergers and acquisitions. Its main idea is to derive a company's Value from similar transactions.

The major steps to precedent transactions are selecting the comparables, determining the multiples used, and applying them to the company in question.

1. Finding Comparable Transactions

This step requires researching similar deals that have occurred. Popular places to find news on M&A transactions are Seeking Alpha, Yahoo Finance, PitchBook, and more.

When looking for a transaction, it is important to base it on a few key metrics, such as industry, location, size, premiums paid, reason for the transaction, and economic conditions.

It is difficult to find many transactions similar to the company in question. This means that when performing a precedent transaction analysis, it is better to have a few super identical transactions than many broadly similar transactions.

2. Determining the Multiples

The next step is to calculate the multiples used for the other companies. Common multiples used in precedent transactions are EV/Sales, EV/EBITDA, and EV/EBITDA.

It is good to calculate the multiples using the previous twelve months and the next twelve months. After this, analysts will calculate the mean, median, max, and min-multiple based on all the company's data.

3. Applying to the company

Once all the multiples are calculated, apply them to the relevant metric. This will give the company in question a firm valuation.

Which Equity Valuation Method Gives The Highest Valuation?

Each valuation method yields a different valuation. This is mainly due to the data, assumptions, and criteria used for the calculation. Typically, precedent transactions have the highest valuation, followed by DCF, comparable company analysis, and market capitalization.

Precedent Transaction carries the highest valuation because of premiums paid during an acquisition. Companies will pay more money to acquire another company because they will be creating synergies.

Discounted cash flow relies heavily on assumptions, which can create a higher valuation than it should be. Those making the discounted cash flow model are often too optimistic, causing the exaggerated valuation.

Comparable company analysis simply compares other companies' values within the market. No premiums or synergies are used because the companies are not acquiring them.

Market Value is just based on what the company in question is being traded for on the stock market. No premiums, assumptions, or other companies are factoring into the Value.

Since each method can bring a company a higher or lower value, it is crucial to factor in each valuation method to arrive at a more fair value.

Conclusion

Equity Valuation is the Value of a company's ownership stake. It does not include debt or non-ownership valuation. Many methods are used to evaluate a company's equity.

The most common equity valuation methods are market valuation, discounted cash flow, comparable company analysis, and precedent transactions. It is important to note that DCF, CCA, and Precedent Transactions can also be used to calculate enterprise value.

Enterprise value is a company's entire Value. It can be calculated using the formula:

Enterprise Value = Market Cap + Total Debt - Cash

Equity valuation should be considered when calculating a company's equity value using DCF, CCA, and president transactions.

Each valuation method has pros and cons. Market Value is easy and quick to use to evaluate a company; however, it cannot be used for a private company. Discounted Cash Flow gives an intrinsic valuation of a company, but all the assumptions can cause accuracy issues.

Comparable company analysis is recognized as being an easy way to calculate a company's Value using market data, but market swings can also sway it.

Precedent Transactions are a great way to value a company in an M&A deal since they factor in premiums. However, finding similar companies and all the information used in the M&A deal takes time and effort.

Precedent transactions have the highest valuation, followed by discounted cash flow and then market valuation.

Understanding how to calculate each equity valuation and its strengths and weaknesses is crucial for making investment decisions and evaluating a company's worth.