How to Determine Market Value of Equity
To determine the market value of a company's equity, the Income Approach to valuation should be used. The Income Approach estimates value by calculating the present worth of the future income expected to be derived from the use or ownership of the asset; in this case the equity of the business. Although there are several valuation methods available to be used under the Income Approach, the Capitalization of Earnings method is most appropriate.
The Capitalization of Earnings method involves quantifying a company's current earnings from operations on an after-tax basis, adjusting them for expected long-term growth, and then capitalizing those earnings based on a risk and growth adjusted capitalization rate. The application of this method results in an indicated value for the equity, or stock, of the company as of a certain date.
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Instructions
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1
Determine the recent normalized historical earnings of the company. To calculate normalized earnings, analyze the reported earnings of the company and make adjustments for non-recurring expenses, non-compulsory expenses, non-cash expenses and reasonable officers' compensation.
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2
Develop an appropriate capitalization rate using the "build-up" method as of the date you want to determine the market value of equity. Using the "build-up" method, the cost of equity consists of the risk-free rate plus an equity risk premium. The risk-free rate used is the twenty-year U.S. Treasury bond rate as of the date you want to value the equity of the company. The equity risk premium reflects the risk premium of large company stocks. To this, add an equity risk premium for small capitalization equity investments and an additional specific company risk. The specific company risk premium addresses the key risks specific to the company, including customer concentration and depth of management.
The company risk premium is based on your professional judgment, but a good starting point is 3%. If the company does not have specific risks, the premium can be less than 3%; if the company has additional key risks not captured in the other premiums, the company risk premium can be more than 3%. An adjustment for industry risk may also be added if warranted. The equity risk premiums and industry risk premium can be found in an independent study published annually by Ibbotson Associates (see Resources).
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3
Adjust the cost of equity calculated above to reflect the expected long-term growth rate. This growth rate is generally 3%. It incorporates economic and industry expectations as well as the company's historical performance. After adjusting for the expected long-term growth rate, the capitalization rate calculation is complete.
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4
Tax impact the normalized pre-tax earnings calculated in Step 1. Multiply the tax impacted normalized earnings by the long-term growth rate used in Step 3 to calculate your capitalization rate, i.e. 3%. Divide the result by the capitalization rate determined in Step 3 to arrive at the market value of the company's total equity.
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5
Divide the market value of the company's total equity by the total number of shares of stock outstanding. The result is the market value of one share of stock, i.e. equity.
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Tips & Warnings
If the company has non-operating assets or liabilities on its balance sheet, you will have to make an adjustment for these items after calculating the market value of equity in Step 4. Non-operating assets, i.e. personal bank accounts and real estate not used in the normal course of business, will be deducted from the market value of equity. Non-operating liabilities, i.e. home mortgage and personal lines of credit, will be added back to the market value of equity.
