What is valuing equity? This post will take a small dive into the common ways to calculate the equity value of a Company, focusing on private businesses.
Valuing Equity Definition
To keep it simple, valuing equity is the ownership interest in a business after subtracting the financial obligations (e.g debt) / debtholder ownership.
Company Value (minus) debtholder ownership = Equity Value
Valuation professionals operate within a framework, which sets the structure for each and every valuation, and it can have a big impact on the value of the exact same company if the structure is altered.
A central element of the valuation framework is the ‘Premise of Value’, which can be determined as:
- ‘Going Concern Value’ = the business continues operating for the foreseeable future, or
- ‘Liquidation Value’ = the business assets are liquidated and the business is closed.
Based on those premises, you can see that if a business was forced to liquidate its assets, it could return a different value than if it was assumed to continue operating as normal.
Another relevant point within the valuation framework is the ‘Standard of Value’. There are several ‘standards of value’ resulting in different estimations of equity value, even if it is the same company, for example:
- ‘Fair Market Value’ = this is a fair price that a person with reasonable knowledge of the relevant facts, would pay under no compulsion to buy, e.g., you, me, your friend Bob, Sarah etc (Given that all are aware of the relevant facts to buy the business). They don’t need to have a particular interest in the business, it is a hypothetical situation.
- ‘Investment Value’ = the value to a specific individual or entity. Think of a retailer buying their wholesaler; there are synergies between both business models that could make the subject company more valuable to the retailer than to a random person in the market; although, synergies are not necessarily implied in each investment value calculation.
So when calculating the ‘Equity Value’ of a company, you should have clearly defined your valuation framework.
How to Value Equity
Once you have a clear valuation framework, a simple way for valuing equity is by determining the ‘book value of equity’. In doing so all you need to do is subtract total liabilities from total assets sitting on your balance sheet. However, this is an accounting based method and can leave out the company’s goodwill, which most of the time in small business is not accounted for in the balance sheet.
So what’s the way to calculate business equity value including any company goodwill? The different methods to value a business will commonly determine the ‘Enterprise Value’ first (includes goodwill). Once you have calculated the Enterprise Value, you can derive the equity value by making a series of adjustments that change on a case-by-case basis. There is not a standard formula to find the equity value and practitioners may differ in their calculatutions, but the underlying concept is as follows:
Equity Value = Enterprise value + surplus cash + surplus net assets – interest bearing debt
Enterprise Value = includes everything used to derive income, including net working capital, and both assets and liabilities directly connected with the operating business.
Surplus Cash = Additional cash on the balance sheet that is not necessary for the operation of the business.
Surplus Net Assets = Surplus assets minus surplus liabilities. Surplus refers to the fact that these are not necessary for the business’ operation.
Interest bearing debt = Normally, short and long term debt to unrelated parties. It may sometimes include debt to related parties which depends on whether it’s disguised equity or if it’s truly debt.
The reason behind adding surplus cash is because some companies may sit on a pile of cash and not need the full amount to fund the operations or financing working capital needs in the short-term.
The valuation methods to identify the Enterprise Value do not account for non-operational assets and liabilities as they are not required to operate the business, however, the surplus assets/liabilities are still owned by the shareholders and hence need to be included when finding the equity value. (Think of an owner of a bakery buying an investment property or a car for their spouse through the business).
Equity Valuation Model Example
- A bakery is owned by 3 sisters all with an equal share. They run a successful small business and it was valued on a Going Concern basis under Fair Market Value.
- The Enterprise Value of the bakery = $800,000
- They operate their business with the correct amount of cash to support the business operations, so no Excess Cash.
- Bank Loan = $100,000
- Each sister has 2 cars bought through the business, of which they use one car each for business purposes (3 cars) and the others are family cars (3 cars). As a result there would be 3 surplus cars (family use) valued at $50,000 total.
Equity Value = $800,000 (Enterprise Value) + $50,000 (surplus cars/assets) – $100,000 (bank loan/debt)
Equity Value = $750,000.
Now, this is where is can get a little tricky, $750,000 is the value of 100% of the Equity Value, but each sister owns 33.33%, so what is the value of each of their 33.33%??
Is it simply $750,000 divided by 3 ?
Depends, but this is often not the case, and the value derived would not be considered ‘Fair Market Value’ if one only divides by 3, because….
33.33% for most situations does not equal ‘control’ of the company, if something important went to a vote, you would need 2 owners to vote the same. So practitioners will often apply a ‘Discount for Lack of Control’ (DLOC).
Additionally being a private business, have you ever thought about how long it would take you to sell it? Could you find a buyer in 3 days? (like selling a share on the stock market) or would a potential buyer be more attracted to buy 100% or just the 33.33% (that doesn’t have control). This is referred to as the Lack of Marketability, and often a discount (DLOM) is applied for this reason too.
So what this means is that your 33.33% parcel of shares will probably not be worth $750,000 / 3, discounts for lack of control and marketability vary considerably based on many factors.
How you calculate the Enterprise Value using the valuation methods within the industry framework is explained in a separate article, see here.
So when next thinking about how much my equity value is worth and the process for valuing equity, make clear the valuation framework and go through the process outlined in this article.