Financial statements contain a lot of financial items like Net Income, Debt, Common Stocks, etc.
Everyone agrees on definition of certain items but the treatment of others can be different.
In general, the value of an asset is the price that a buyer pays to a willing seller.
The problem is that there are several types of value: Fair value, Enterprise value, Market Capitalization, Equity value, Intrinsic value, Book value and many others.
Remember, as long as you can explain how to calculate a particular value it will be fine even if somebody disagrees.
You always can adjust your formulas if there is a logic reason to do so.
Takeover isn’t a purchase of common shares only
When taking into account the whole company concept, there is a way to measure how much a purchasing company should pay to buy out the whole company.
Traditionally, investors operate with the following terms:
Firm value (FV) is a very easy to understand.
It is simply the market value of the total business which is equal to market value of all operating and non-operating assets.
Enterprise Value (EV) is a firm value minus non-operating assets.
If you buy some company why do you need all of the non-operating assets? Correct? That’s why EV is said to be the market value of the operating business.
Market capitalization value or Equity value is the market value of common stock.
In practice, the company’s retained earnings aren’t used in the computation of market capitalization because the market stock price theoretically already reflects the retained earnings of the company. Therefore, Market capitalization is simply a number of shares outstanding multiplied by the current market price.
What about preferred stocks? They are also considered equity although it is often treated like debt because the dividend is somewhat like debt interest.
Following the concept of EV we come to the final definition of market capitalization value:
FV – market value of debt – market value of minority interest – market value of preferred equity
or
EV – market value of debt – market value of minority interest – market value of preferred equity+ market value of non-operating assets
Let’s use a well-known equation Assets = Liabilities + Total Equity.
Assets are classified as operating assets and non-operating assets.
Total shareholder equity in a simplest form consist of Paid-in capital (Common and preferred stocks), retained earnings that belong to common shareholders’ equity.
By adding minority and non-controlling interest to total shareholder equity we obtain total equity.
The illustration is as follows:
Firm value and Market capitalization are common items so there is no complexity with calculation.
EV is always somewhat subjective and it is often done different ways. As been already written it is a firm value minus non-operating assets or if we expand the definition more precisely, it is:
EV = Market Capitalization (Equity Value) + Preferred Stock + Net Debt + Minority Interest + Adjustment for leases
To calculate Market capitalization, the number of common shares outstanding needed. This number, known as diluted shares, should take into account any restricted shares resulting from the exercise or conversion of options, warrants and convertible securities.
Preferred equity that is not convertible into common stock is treated as a financial liability equal to its liquidation value and included in net debt
Net debt is equal to total debt less cash and cash equivalents.
Minority interest represents the interest of non-controlling shareholders in the net assets of a company.
Leases are either classified as capital leases or operating leases. Operating leases are off-balance sheet items, financial leases are on the Balance Sheet. Leases have interest payments and should be included into EV.
Valuation part of common shares
Investment in a particular company often deals with common shares. Here are two important definitions of value.
Intrinsic value, can be easily explained by the present value of the expected future cash flows discounted at the rate of return.
Book value equals total common stockholders’ equity divided by average number of common shares outstanding.
There are a gap between book value (the reported accounting number) and the intrinsic value.
Book value is an accounting concept, whereas intrinsic value is the economic concept, both are compared with each other in order to make a judgment about current stock price of the company.