Equity Valuation Methods

The term equity valuation refers to the process of determining the fair market value of equity securities. The equity valuation method divided into three parts:-

  1. Balance sheet method
  2. Dividend discount cash flow method
  3. Relative value method

    Balance sheet Method: – It is a method or a technique to determining the fair market value of equities by utilizing the balance sheet information. Under this method, we calculate book value, Liquidation value or replacement cost. The formulas are given below to calculate book value, liquidation value or replacement cost to ascertain the value of equity.

Formulas:-

  1. BOOK VALUE: – Book value means the net worth of the company. Book value as per the balance sheet is considered the value of equity. We can calculate the net worth of the company is as below:-
       Net worth =Equity Share capital + Preference Share Capital + Reserves & Surplus – Miscellaneous Expenditure (as per B/Sheet) – Accumulated Losses
  1. LIQUIDATION VALUE: – Liquidation value method is one of the techniques under the balance sheet method to calculate the equity value. Liquidation value is the value that realized if the firm is liquidated today and that value is considered the value of equity.
Liquidation Value = Net Realizable Value of All Assets – Amounts paid to All Creditors including Preference Shareholders.
  1. Replacement cost method: – This method is also known as Tobin’s Q because it was developed by James Tobin. It is quantified as Q-Ratio. James Tobin hypothesis that total value of the firm is equal to the replacement value of their assets minus liabilities.

Tobin’ Q-Ratio formula:

Q ratio= Market price of firm/ Replacement cost.

 

  1. DIVIDEND DISCOUSNT CASH FLOWS METHOD:- The formulas of Models to calculate the dividend are given as below-
  2. General Model:-   V0 =∑  Dt//(1+k)t
  • V0 = Value of Stock
  • Dt = Dividend
  • k = required return
  1. No growth model:-

V0 = D/ K

Example:

E1 = D1 = $5.00

k = .15

V0 = $5.00 / .15 = $33.33

  1. Constant Growth Model: –

D0 (1+g)/ k-g

  • g= constant perpetual growth rate

EXAMPLES:-

E1 = $5.00      b = 40%                       k = 15%

(1-b) = 60%    D1 = $3.00                 g = 8%

V0 = 3.00 / (.15 – .08) = $42.86

  1. Multistage Growth Models

            P = D0 ∑  (1+g1)/(1+k) +DT(1=g2)/ (k-g2)(1+k)t

  • g1 = first growth rate
  • g2 = second growth rate
  • T = number of periods of growth at g1

Example: –

D0 = $2.00      g1 = 20%         g2 = 5%

k = 15%          T = 3               D1 = 2.40

D2 = 2.88       D3 = 3.46       D4 = 3.63

V0 = D1 / (1.15) + D2 /(1.15)2 + D3 /(1.15)3 + D4 / (.15 – .05) ( (1.15)3 V0 = 2.09 + 2.18 + 2.27 + 23.86 = $30.40

  1. Relative value method: – Relative value method is also known as earnings multiples or comparable method because they use competitors value to derive the value of equity. Under this method, we need to calculate the following ratios to ascertain the equity value of the company.
  • Price to Earnings ratio = Market price per shares/ Earnings per share
  • Price to Book Value Ratios= Stock Price / Book Value per share

Price to Sales Ratio= Price Per Share / Annual Net Sales Per Share

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