Equity Value per Share
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When we value a business using FCFF or FCFE, we are able to calculate the value of operating assets generating cash flows. We need to go several steps further to arrive at the value of equity per share. Some of such steps are adjustments for cash and cross holdings. We might want to simply add them to our arrived valuation and let that be. However, this isn’t appropriate in all circumstances. Next, we need to subtract the debt (in case of FCFF) to arrive at the value of equity. This value of equity has two classes of claimholders. Managers and investors may have claim on the company if they’ve been given options. These options need to be netted out before we can arrive at the value per share.
Consider a company which earns a return on capital (RoC) just its cost of capital (CoC). It does not create value for the shareholders, but neither does it destroy any value. For companies such as this, cash is a neutral asset. The value of cash on its books can be called as the fair value of the cash. Taking the argument further, consider a company that does not earn its CoC. This means this company has made some bad investments. Cash in the books of a company by itself does not hurt an investor. What does hurt the investor is what the managers do with that cash. If a company is unable to earn its CoC, then the cash will be wasted with the company. In such a scenario, the investor must discount the cash. The management of such a business wastes cash rather than pay it out to the investors as dividend. Conversely, if a company earns more than its CoC, the cash on its books should be valued at a premium. But that is only applicable if the company does not have adequate access to capital markets. With access to capital markets, there’s no need for a company to retain large cash balances. So a premium to cash may be appropriate for emerging market companies, but not for those in developed markets. Further, during times of volatility for such companies, they can use the cash to survive till the economy picks up again, as well as use it to acquire assets from other companies not faring well in the economic downturn.
The second point of contention are cross holdings as there’s no reliable mechanism of accounting for cross-holdings. To estimate cross-holdings effectively, we need to know how they’re accounted for in the financial statements. Often they’re valued at book values. In a perfect world, we’d value the parent company on a standalone basis and then value each cross-holding separately. This allows us to treat each company with its own cash flows, growth, and risk rather than apply one CoC and growth rate across the board. However, to do this we need the full financials of each cross-holding company, which is often tough to come by. So there’re 2 compromise solutions. (a) If the cross-holding is in a public traded company, we already have a market price. This is cheating since the idea behind intrinsic valuation is that markets can be wrong and we’re trying to estimate value on our own. But that gets complicated with investments in too many companies. (b) If the cross holdings are in private companies, then we can use the PB ratio from listed companies in the same sector. We use the PB ratio as the record of investment in the cross-holding company is at book value.
Next, we need to look at unutilized assets – assets that do not form a part of the operations but are under the ownership of the company. We can either count the value of the cash flows from the asset or the value of the asset, but not both. That’s double counting. Unutilized assets are those who do not contribute to the cash flows in our FCF models. We prepare a collection of such assets and estimate a market value for them. Sometimes companies have real-estate holdings worth more than the rent they generate. So we can have an option to either value the company as a going concern based on its cash flows or we can value it as a collection of real estate holdings, but we can’t add the two up.
Last stop is the equity options to the management or investors. The companies that give a lot of options to their employees tend to be young high-growth risky companies. Long term options on risky companies may be valuable pieces of equity. Often, analysts value options based on exercise value, i.e. what is the option worth if it were exercised as on the valuation date. Sometimes they dilute the number of shares to value the options. That undermines how much equity gets given away as such values can be low even for options with significant economic value. So such claims should be valued as options in an option-pricing model. This is the value that needs to be subtracted from the value of the equity to arrive at the value of equity per share outstanding. Similar mechanism may be used for future option values. Companies use options to compensate employees. Since we treat the rest of the compensation as operating expenses, we must treat options in the same light. If we issued these options to the market and used the cash to pay the employees, it’d be cash compensation. So equity options are compensation. Future options are just such compensation exercised in the future.
In summary, getting from the value of the operating assets to value of equity per share can be problematic because people try to take shortcuts. If we don’t take shortcuts and work one step at a time, there’s nothing intensely difficult about this process.