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<\/a><\/h2>\nValuing Equity Definition<\/strong>\u00a0<\/strong><\/h2>\nIn short, valuing equity is the ownership interest in a business after subtracting the financial obligations (e.g., debt)\/debtholder ownership).<\/p>\n
Company Value \u2013 Debtholder Ownership = Equity Value<\/p>\n
Valuation professionals operate within a framework that sets the structure for each and every valuation, which can have a big impact on the value of the exact same company if the structure is altered.<\/p>\n
A central element of the valuation framework is the \u201cpremise of value\u201d, which can be determined as either:<\/p>\n
\n- Going concern value<\/strong>: the business continues operating for the foreseeable future<\/li>\n
- Liquidation value<\/strong>: the\u00a0business assets<\/strong><\/a>\u00a0are liquidated and the business is closed<\/li>\n<\/ul>\n
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.<\/p>\n
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<\/p>\n
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:<\/p>\n
\n- Fair market value<\/strong><\/a>: 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, etc.), given that the person is aware of the relevant facts involved in buying the business. They don\u2019t need to have a particular interest in the business\u2019 this is simply a hypothetical situation.<\/li>\n
- Investment value<\/strong>: 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. However, synergies are not necessarily implied in each investment value calculation.<\/li>\n<\/ul>\n
Therefore, when calculating the equity value of a company, you should have clearly defined your valuation framework.<\/p>\n
How to Value Equity <\/strong><\/h2>\nOnce you have a clear valuation framework, a simple way for valuing equity is by determining the \u201cbook value of equity\u201d. In doing so, all that\u2019s required is to subtract total liabilities from total assets sitting on your\u00a0balance sheet<\/strong><\/a>. However, this is an accounting based method and can leave out the company\u2019s goodwill, which, most of the time in small business, is not accounted for in the\u00a0balance sheet<\/strong><\/a>.<\/p>\nSo then, what\u2019s the way to calculate business equity value including any company goodwill? The different methods to value a business will commonly determine the enterprise value<\/strong><\/a> first (which includes goodwill). Once you\u2019ve calculated the\u00a0enterprise value<\/strong><\/a>, you can derive the equity value by making a series of adjustments that change on a case-by-case basis. There isn\u2019t a standard formula to find the equity value, and practitioners may differ in their calculations, but the underlying concept is as follows:<\/p>\nEquity Value =\u00a0Enterprise Value<\/strong><\/a>\u00a0+ Surplus Cash + Surplus Net Assets \u2013 Interest Bearing Debt<\/p>\nEnterprise Value<\/strong><\/a>: includes everything used to derive income, including\u00a0net working capital<\/strong><\/a>, and both assets and liabilities directly connected with the operating business<\/p>\nSurplus Cash<\/strong>: additional cash on the\u00a0balance sheet<\/strong>\u00a0<\/a>that is not necessary for the operation of the business<\/p>\nSurplus Net Assets<\/strong>: surplus assets minus surplus liabilities. \u201cSurplus\u201d refers to the fact that these are not necessary for the business\u2019 operation<\/p>\nInterest Bearing Debt<\/strong>: normally, short- and long-term debt to unrelated parties. It may sometimes include debt to related parties, which depends on whether it\u2019s disguised equity or if it\u2019s truly debt<\/p>\nThe reason behind adding surplus cash is that 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.<\/p>\n
The valuation methods to identify the\u00a0enterprise value<\/strong><\/a>\u00a0do 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 therefore need to be included when finding the equity value. (Think of a bakery owner buying an investment property or a car for their spouse through the business).<\/p>\nEquity Valuation Model Example:<\/strong><\/h2>\n\n- A bakery is owned by three sisters all with an equal share. They run a successful small business, and it was valued on a going concern basis under\u00a0fair market value<\/strong><\/a><\/li>\n
- The\u00a0enterprise value<\/strong><\/a>\u00a0of the bakery = $800,000<\/li>\n
- They operate their business with the correct amount of cash to support the business operations, therefore no excess cash<\/li>\n
- Bank loan = $100,000<\/li>\n
- Each sister has two cars bought through the business. They use one car each for business purposes (three cars) and the others are used as family cars (three cars). As a result, there would be three surplus cars (for family use), valued at $50,000 total<\/li>\n<\/ul>\n
Equity Value = $800,000 (Enterprise Value<\/strong><\/a>) + $50,000 (surplus cars\/assets) \u2013 $100,000 (bank loan\/debt)<\/p>\nWhich means:<\/p>\n
Equity Value = $750,000<\/p>\n
<\/p>\n
Now, this is where things 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?<\/p>\n
It depends, but this is often not the case. The value derived would not be considered fair market value<\/strong><\/a> if we only divide by 3, because:<\/p>\n33.33% for most situations does not equal \u201ccontrol\u201d of the company. If something important went to a vote, you would need two owners to vote the same. So practitioners will often apply a \u2018Discount for Lack of Control<\/strong><\/a>\u2019 (DLOC).<\/p>\nAdditionally, as a private business, have you ever thought about how long it would take you to sell it? Could you find a buyer in three days (as with selling a share on the stock market)? Or would a potential buyer be more attracted to buy 100% or just the 33.33% (which doesn\u2019t have control)? This is referred to as the Lack of Marketability, and often a discount for lack of marketability (DLOM) is applied for this reason, too.<\/p>\n
So then, what this means is that your 33.33% parcel of shares will probably not be worth $750,000 divided by 3. Discounts for lack of control and marketability vary considerably based on many factors. They can often be in the range of 20-40% each.<\/p>\n
<\/p>\n
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.<\/p>\n
<\/p>\n
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:<\/p>\n
- \n
- Fair market value<\/strong><\/a>: 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, etc.), given that the person is aware of the relevant facts involved in buying the business. They don\u2019t need to have a particular interest in the business\u2019 this is simply a hypothetical situation.<\/li>\n
- Investment value<\/strong>: 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. However, synergies are not necessarily implied in each investment value calculation.<\/li>\n<\/ul>\n
Therefore, when calculating the equity value of a company, you should have clearly defined your valuation framework.<\/p>\n
How to Value Equity <\/strong><\/h2>\n
Once you have a clear valuation framework, a simple way for valuing equity is by determining the \u201cbook value of equity\u201d. In doing so, all that\u2019s required is to subtract total liabilities from total assets sitting on your\u00a0balance sheet<\/strong><\/a>. However, this is an accounting based method and can leave out the company\u2019s goodwill, which, most of the time in small business, is not accounted for in the\u00a0balance sheet<\/strong><\/a>.<\/p>\n
So then, what\u2019s the way to calculate business equity value including any company goodwill? The different methods to value a business will commonly determine the enterprise value<\/strong><\/a> first (which includes goodwill). Once you\u2019ve calculated the\u00a0enterprise value<\/strong><\/a>, you can derive the equity value by making a series of adjustments that change on a case-by-case basis. There isn\u2019t a standard formula to find the equity value, and practitioners may differ in their calculations, but the underlying concept is as follows:<\/p>\n
Equity Value =\u00a0Enterprise Value<\/strong><\/a>\u00a0+ Surplus Cash + Surplus Net Assets \u2013 Interest Bearing Debt<\/p>\n
Enterprise Value<\/strong><\/a>: includes everything used to derive income, including\u00a0net working capital<\/strong><\/a>, and both assets and liabilities directly connected with the operating business<\/p>\n
Surplus Cash<\/strong>: additional cash on the\u00a0balance sheet<\/strong>\u00a0<\/a>that is not necessary for the operation of the business<\/p>\n
Surplus Net Assets<\/strong>: surplus assets minus surplus liabilities. \u201cSurplus\u201d refers to the fact that these are not necessary for the business\u2019 operation<\/p>\n
Interest Bearing Debt<\/strong>: normally, short- and long-term debt to unrelated parties. It may sometimes include debt to related parties, which depends on whether it\u2019s disguised equity or if it\u2019s truly debt<\/p>\n
The reason behind adding surplus cash is that 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.<\/p>\n
The valuation methods to identify the\u00a0enterprise value<\/strong><\/a>\u00a0do 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 therefore need to be included when finding the equity value. (Think of a bakery owner buying an investment property or a car for their spouse through the business).<\/p>\n
Equity Valuation Model Example:<\/strong><\/h2>\n
- \n
- A bakery is owned by three sisters all with an equal share. They run a successful small business, and it was valued on a going concern basis under\u00a0fair market value<\/strong><\/a><\/li>\n
- The\u00a0enterprise value<\/strong><\/a>\u00a0of the bakery = $800,000<\/li>\n
- They operate their business with the correct amount of cash to support the business operations, therefore no excess cash<\/li>\n
- Bank loan = $100,000<\/li>\n
- Each sister has two cars bought through the business. They use one car each for business purposes (three cars) and the others are used as family cars (three cars). As a result, there would be three surplus cars (for family use), valued at $50,000 total<\/li>\n<\/ul>\n
Equity Value = $800,000 (Enterprise Value<\/strong><\/a>) + $50,000 (surplus cars\/assets) \u2013 $100,000 (bank loan\/debt)<\/p>\n
Which means:<\/p>\n
Equity Value = $750,000<\/p>\n
<\/p>\n
Now, this is where things 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?<\/p>\n
It depends, but this is often not the case. The value derived would not be considered fair market value<\/strong><\/a> if we only divide by 3, because:<\/p>\n
33.33% for most situations does not equal \u201ccontrol\u201d of the company. If something important went to a vote, you would need two owners to vote the same. So practitioners will often apply a \u2018Discount for Lack of Control<\/strong><\/a>\u2019 (DLOC).<\/p>\n
Additionally, as a private business, have you ever thought about how long it would take you to sell it? Could you find a buyer in three days (as with selling a share on the stock market)? Or would a potential buyer be more attracted to buy 100% or just the 33.33% (which doesn\u2019t have control)? This is referred to as the Lack of Marketability, and often a discount for lack of marketability (DLOM) is applied for this reason, too.<\/p>\n
So then, what this means is that your 33.33% parcel of shares will probably not be worth $750,000 divided by 3. Discounts for lack of control and marketability vary considerably based on many factors. They can often be in the range of 20-40% each.<\/p>\n
<\/p>\n
- The\u00a0enterprise value<\/strong><\/a>\u00a0of the bakery = $800,000<\/li>\n
- Investment value<\/strong>: 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. However, synergies are not necessarily implied in each investment value calculation.<\/li>\n<\/ul>\n
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