Equity Value

A measure of how much shareholding equity investors have in a company.

Equity value (EV) measures how much shareholding equity investors have in a company. This can also be understood as how much of the company these investors are entitled to. It can be calculated simply by multiplying common shares and share price.

Equity Value

Equity Value (EV) = Common Shares Outstanding * Share Price

Another way to understand this is to focus on market capitalization. Market capitalization is the same as equity value; both are used in different contexts.

Simply, it refers to the amount equity investors will receive after all other stakeholders are paid. Equity investors are the last in line if a company winds up.

It is not to be confused with the book value of equity, which is the equity amount recorded on the balance sheet

The book value of equity stands for the amount of cash left after all the company's assets are sold and debts paid. Although similar in the names, they are different concepts.

The actual calculation for the figure is quite simple. But, first, we multiply the outstanding shares by the current share price.

To fully understand the concept, it is essential first to recognize the basic difference between common and diluted shares.

Common shares 

It is a more straightforward form of equity ownership. A common share grants the owner the right to vote on the corporation's decisions while ranking them lower in the dividend priority list (capital stack). 

Shaking hands

Essential to keep in mind that along with being paid dividends last, in the situation the company goes bankrupt, the common equity investors will also be the last ones to be paid. 

The difference is that they would not be demanding dividends but simply their own money back in a situation like this. Since their money is now tied to the company's stock price, the shares would be worthless even if they get paid.

Awareness of such concepts is essential since many investors must look at such parameters before investing in a stock.

Apart from the capital structure considerations, common shares also represent the floor for the number of the company's shares. In addition, we may have preferred shares, warrants, RSUs, RSAs, and stock options.

Note

Common shares outstanding are also called basic shares outstanding

This information is vital because it helps us properly evaluate an equity value figure.

For instance, when performing a comparable valuation analysis, you must compare a company's basic EV with its peers using the same metric. Therefore, we cannot compare the basic value with the diluted.

These affect the number of shares and will also impact the value calculation.

Diluted shares outstanding

The different kinds of equity instruments issued by companies create a dilution effect. Much like a glass of orange juice that, if you put water in, it will get weaker, the same rationale happens with basic and diluted shares. 

Diluted means more shares and thus will lower earnings per share figures. The earnings per share number is a crucial indicator of the company's profitability and are closely watched by investors. 

In a valuation context, the accretion/dilution analysis is a gauge for the upside potential of an M&A transaction. If the acquirer's earnings per share increases after the transaction, the deal is said to be accretive, which is profitable for investors. Otherwise, it is said to be dilutive.

When assessing the number of diluted shares of a company, we must take into consideration the following instruments:

  • Stock options
  • Warrants
  • Restricted stock units (RSUs)
  • Restricted stock awards (RSAs)

Each of these will be added to the common shares to arrive at the diluted amount. They are used for employee compensation and payment.

Companies use these instruments to incentivize their employees to fulfill their goals and perform better. The ways they use them depend on the top management of a company.

For instance, the company may have a performance compensation policy that pays its employees according to their share price. Stock options have an exercise price, which is fixed. The more the share price exceeds it, the better for the employees once the votes are vested.

In short, the vesting period is the time frame in which an employee is entitled to but not yet the owner of a particular compensation benefit. They may only exercise ownership once the vesting period is over.

Let's understand this with a simple example. Suppose you start working today for Company A and receive 1,000 shares with a vesting period of 5 years. That means you will only be the owner of the shares after these five years.

The catch is that the share price has to increase after that period for the process to be worth it. So companies use it to drive employees towards reaching their goals and higher performance.

All these instruments are used the same way: employee compensation; as they are vested, the share count increases, and so does the dilution effect.

What is it used for?

Along with enterprise value, it is a measure crucial to valuation analysis. They are related through debt and cash combination. Enterprise value equals equity value plus all the business's debt, subtracted from cash. 

Discussion 2

Valuation analysis is an important topic; it is usually used as a background for a transaction. For example, you must know what it is worth to purchase something, right? The same goes for companies.

When a potential buyer approaches a potential seller, a valuation analysis will be carried out as a part of the due diligence process.

While valuation is a long process with several steps, the starting point is this value. It is the starting point because equity investors are the last in the capital stack. So when we compute the company's value from the bottom-up, their slice will be ranked lower.

The end goal is to arrive at a figure for enterprise value. It is achieved by summing the company's debt net of outstanding cash to the equity value. While it may seem confusing that we subtract cash and add debt. The reasons for this are multifold:

  • When a company purchases, all its debt will be consolidated into the acquirer's statements.
  • The enterprise value accounts only for the value of the business as a whole; it doesn't consider the financing option. A $100,000 house purchased with 100% mortgage financing or with 100% cash is still the same $100,000 house.
  • We assume that once the company is acquired, the acquirer will use the cash to settle any outstanding debt.

As explained earlier, EqVal represents the same as a company's market capitalization: the multiplication between outstanding shares and shares price. 

It is important to note that it is calculated using the number of common shares instead of the diluted shares outstanding

This is to ignore the effect of dilutive securities such as warrants, stock options, and others. Since EqVal aims to measure how big a company's market capitalization is, they stay out of the calculation since those securities are not yet outstanding.

Relationship between equity value and enterprise value

The relationship between equity and enterprise value can sometimes be confusing. While enterprise value accounts for the value added by all the business's operations, equity value is the amount owed only to equity investors.

Puzzle pieces

Since those investors are the last on the capital stack, this value is usually less than enterprise value. So the main question is, how much?

Bear in mind that enterprise value is concerned with the amount of the business that accounts for all investors' stake in the company, which suggests it will also consider the debt owed on top of the equity amounts.

Enterprise value = EV + net debt

From the formula, we know that if we have the equity value figure, we add the net debt of the business to arrive at enterprise value. 

What exactly is the net debt?

Net debt is the amount owed to creditors, net of cash. 

This is a fundamental assumption because it states that the acquirer would use all the acquirer's cash to settle any debt whenever an acquisition deal takes place. Therefore, we add the net debt figure instead of the total debt.

Report

This assumption is built upon the capital stack concept in corporate finance. Different investors have different layers of claims in the company, all according to their respective risks.

Debt investors (bondholders) are on the top of the stack, thus, are less risky and yield smaller returns.

Equity investors are at the bottom, most at risk, and earn the most significant returns. So at the end of the day, it is all derived from the risk and return logic.

Let's look at an example of equity and enterprise value in practice.

Suppose John owns a house for $500,00. Also, assume that John paid the entire amount upfront for the home.

Now James owns a house in the same neighborhood as John. James's home, too, is worth $500,000. The difference is that James borrowed $250,000 in a mortgage to finance the house and paid the other 250,000 upfront. Which of the places is worth more? They are worth the same. 

For a potential buyer, it doesn't matter whether the property was financed with all cash or half cash and half mortgage; the intrinsic value is analogous to enterprise value. It is what the business is worth, regardless of its capital structure.

Equity value, on the other hand, is the share of the business owned by its equity investors, which in our example, for John, is the same 500,000 as he paid the entire value upfront, while for James, it is 250,000 since he has 250,000 outstanding in debt.

That is why enterprise value equals EV plus net debt. What a business is worth doesn't change regardless of the financing method.

Use in valuation multiples

In valuation analysis, this value is used to obtain some valuation multiples. Each multiple has its particular application, depending on the company's capital stack. Since this value is available only to shareholders, EVs multiples are combined with earnings figures.

Analysis and graphs

The primary equity multiple is the price-to-earnings Ratio.

P/E Ratio = EV/ Net Earnings

Since it considers net earnings, it is appropriate for companies in a mature stage with stable profits.

Equity multiples are generally appropriate for mature companies with stable profits since they represent the equity investors' stake. Another popular equity multiple is the earnings per share figure.

Earnings per share (EPS) = Net Income/Number of shares

The consideration of diluted vs. common shares outstanding applies here. Depending on the analysis, we may use one or the other. While the weak figure is more thorough, the number of common shares allows for more quick calculations.

There are other equity multiples, such as:

1. Price-to-book ratio

It compares the company's market cap to the book value of its equity. Usually, it is a measure gauged by investors to assess if a stock is cheap or expensive.

Price to book ratio = Market cap/Book value of equity

2. Price to cash flow ratio

As the name suggests, it compares the stock price to its cash flow per share. Since value is derived from cash flow, the lower it is, the more undervalued the stock is, and thus, the better.

Price to cash flow ratio = Share price/cash flow per share.

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Researched and Authored by Lucas

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