What are various equity valuation methods?
The term equity valuation refers to the process of determining the fair market value of equity securities. In simpler terms, it’s figuring out what a company is truly worth to investors.
There’s no single, perfect way to value a company. Different analysts use various methods and assumptions, leading to a range of possible values.
In this blog post, we’ll shed light on the most common equity valuation methods, providing you with a clear understanding of how companies are assessed.
1. Balance sheet Method
It is a method or a technique for 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:
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. |
LIQUIDATION VALUE: The liquidation value method is one of the techniques under the balance sheet method to calculate the equity value. Liquidation value is the value that is 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. |
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 is that the 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. |
2. Dividend Discount Cash Flow Method
The formulas of Models to calculate the dividend are given below-
General Model:- V0 =∑ Dt//(1+k)t
V0 = Value of Stock
Dt = Dividend
k = required return
No growth model
V0 = D/ K
Example: –
E1 = D1 = $5.00
k = .15
V0 = $5.00 / .15 = $33.33
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) = $42.8
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
3. Relative Value Method
The relative value method is also known as earnings multiples or comparable method because they use competitors values 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 share/ 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
Conclusion
Equity valuation methods provide investors with a framework to assess a company’s intrinsic value, but it’s important to remember there’s no one-size-fits-all approach. The most appropriate method depends on the company’s specific characteristics and industry.