Introduction to Stock Valuation Part 1 – Equity & Enterprise Value, Financial Statements
Stock Valuation – Equity and Enterprise Value
If you want to learn how to value stocks, this introduction to stock valuation is designed for you. In this series of blog posts we review a number of valuation techniques and work though some current examples. Once you have worked though the text and examples you will be able to apply the frameworks to the stocks you are interested in.
This is (hopefully) a practical blog series you can use to understand how to value stocks. Stock valuation is a methodical process that helps you understand the boundaries of what a company is worth and lets you zone in on the ultimate value. Values changes when the inputs change.
There are a few things I would like to start with before you jump into the details below:
Valuation is based on:
- Assumptions about the future of the company
- Assumptions about how it compares to other companies
- Assumptions (or assessments, much better) of the value of the assets the company has and the debts and obligations it owes
Those 3 statements capture the 3 broad ways we look at valuation
- On the basis of Cash Flow
- On the basis of Comparable Companies
- On the basis of the Assets the company has
We will go over each of these. First let’s start with a few terms to set the stage:
We need to set the stage with a few definitions: equity vs enterprise value, book vs market value
Equity and Enterprise Value:
We hear the term equity a lot when dealing with the stock market.
- Equity in the stock market context is the stock (share certificates) that gets traded between investors and can be common or preferred (common stock, preferred stock).
- Equity on financial statements (Balance Sheet specifically) is part of the value of the company and includes the amount of funds contributed by the owners plus the retained earnings (total amount of gains and losses of net income the company has had over time) (Source: Investopedia)
Enterprise Value is the total value of the company and includes both the equity in the company as well as the debt the company has. Enterprise value is generally thought of in market value not book value terms. i.e. we want to know what someone would pay for the company.
Figure 1. Enterprise vs Equity Value
Well 2 things actually:
- We can calculate the value of the Equity directly (equity is what we want to know because we can calculate stock price from it) or
- If we can calculate the total value of the company, we can subtract the debt to get the value of the equity (so we can calculate stock price from it)
There are 3 financial statements of interest to the new investor: (Source: Investopedia)
Income Statement: a financial statement that reports a company’s financial performance over a specific accounting period. Financial performance is assessed by giving a summary of how the business incurs its revenues and expenses through both operating and non-operating activities.
Balance Sheet: A balance sheet is a financial statement that summarizes a company’s assets, liabilities and shareholders’ equity at a specific point in time. (Sample below)
Cash Flow Statement: a financial statement that shows how changes in balance sheet accounts and income affect cash and cash equivalents, and breaks the analysis down to operating, investing and financing activities.
Look forward to our next article in the stock valuation introduction series, where we will be discussing Book Value and Market Value.