Equity analysis for amateurs


There are numerous ways to calculate the equity in a business. The method that an investor will use depends on the type of business. With that in mind, here are the most common methods and where they are best used: Method one – Assets vs. liabilities – Many companies have significant inventories of real products as well as amounts due and amounts payable. Valuing the equity in these companies is fairly straightforward. First, total all the current and long-term assets – these include things like real estate, equipment, inventory and accounts receivable – to arrive at the “total assets” number. Next, do the same for current and long-term liabilities – ensure that payroll due and accounts payable are included. Finally, subtract the latter from the former and you will have an approximate value for the equity in the company. Method two – Earnings multiples – A more sophisticated, but still well-accepted, method for valuing any business – especially service ones – is to use their earnings as a basis for their equity value. Generally, this method determines a value by calculating the net present value of the future earnings of the business. It is a technical process that discounts future cash earnings and applies multipliers to the EBITDA (earnings before interest, depreciation and amortization) while trying to use all the techniques that stock analysts use to value public companies. Method three – Free cash flow – Some companies – Amazon, eBay and Google come to mind – have never made a profit and yet they are immensely valuable when it comes to their equity. The secret is in the amount of cash flow they generate that allows subsidiaries to exist, thrive and generate their own profits. In addition, with a lot of free cash flow, these types of companies are able to act like banks – without the licensing and regulatory hassles – by using the capital of their customers to attain their own financial ends. Don’t be fooled. This valuation method is quite complicated – expensive too! – and requires the expertise of CPAs, other financial analysts and usually lawyers. Method four – The market approach – Probably the most subjective approach to valuing the equity in a business, this approach is the one most favored by small business owners. This method compares a business to others in the same industry, of the same size and within the same geographic area, trying to consider such factors as comparables, market conditions and the size of the opportunity. The problem with this method is that most business sellers overvalue the company’s worth while buyers are more likely to place a less than reasonable value on such nebulous – that is, hard to quantify exactly – factors such as goodwill, customer base and potential growth. A final thought – In many cases, valuing the equity in a business is more art than science. It requires the seller to substantiate the scientific aspect of the process while the buyer must also appreciate the art. Otherwise, it is very difficult to come to an agreed upon value. In every case, however, a meeting of the minds must be engineered or there will simply be no sale – disappointing the parties on both sides of the deal.


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