MODULE 6

OBJECTIVES

1. Discuss the Equity Valuation Methods

2. Explain the Balance Sheet Methods
3. Determine the value for each Balance Sheet Methods
 Equity Valuation Methods
• The main purpose of equity valuation is to estimate a
value for a firm or its security. A key assumption of any
fundamental value technique is that the value of the
security (in this case an equity or a stock) is driven by
the fundamentals of the firm’s underlying business at the
end of the day.
Equity Valuation Methods can be classified into:
1. Balance Sheet Methods
2. Discounted Cash Flow Methods
3. Relative Valuation Methods
 Balance Sheet Methods / Techniques

• Balance sheet methods are the methods that utilize the

balance sheet information to value a company.
• These techniques consider everything for which
accounting in the books of accounts is done.

1. Book Value Method

2. Liquidation Value Method
3. Replacement Cost Method
 Book Value Method

• In this method, book value as per the balance

sheet is considered the value of equity.
• Book value means the net worth of the company.
Net worth is calculated as follows:
Net Worth = Equity Share capital + Preference Share
Capital + Reserves & Surplus – Miscellaneous
Expenditure (as per B/Sheet) – Accumulated Losses.
 Liquidation Value Method
• In the liquidation cost method, liquidation value is
considered the value of equity.
• The liquidation value is the value realized if the firm is
liquidated today.

Liquidation Value = Net Realizable Value of All Assets

– Amounts paid to All Creditors including Preference
Shareholders.
 Replacement Cost Method
• In the replacement cost method, the value of equity is
the replacement value.
• It means the cost that would be incurred to create a
duplicate firm is the firm’s value.
• It is assumed that the market value and replacement
value will coincide in the long run.

Equity Value = Replacement Cost of Assets – Liabilities.

 1. Book Value of Equity Valuation
• The book value of equity, more widely known as
shareholder’s equity, is the amount remaining after all
the company assets are sold, and all the liabilities are
paid off.

Formula as follows:
Book Value of Equity = Total Assets – Total Liabilities
 Following are the important components of the formula of Book Value.

üThis is the amount that owners contribute to the company.

üThis component is commonly known as common stockholder’s
equity or common stock of the company.

üPreferred shares can be classified as equity or financial liabilities. This

classification is based on their characteristics.
üFor example, perpetual, non-redeemable preferred shares are classified as
equity.
ü On the other hand, preferred shares with the mandatory redemption of a
fixed amount at a fixed future date are considered to be a financial
liability.
These are the shares that have been repurchased by the company, and the
company holds them as treasury shares rather than canceling them
Preferred Shares
ØRetained Earnings
This is the cumulative amount of earnings that have not been paid to the
owners of the company as dividends.
ØAccumulated Other Incomes
Other comprehensive income includes:
Net income (As per income statement)
Other comprehensive income (As reflected in accumulated other
comprehensive income)
ØNoncontrolling Interest (Minority Interest)
This is the equity interests of minority shareholders in the
subsidiary companies held by the parent. The parent
company does not wholly own these subsidiary companies.
• In the above financial statement, the
book value of equity is US$ 134.05
billion (as highlighted).

This amount includes common stock,

retained earnings, and other equity. If
we apply it to the formula –

Book Value of Equity = Total Assets –

Total Liabilities

Apple Inc. (Book Value) = US$ 375.32

billion – US$ 241.27 billion = US$
134.05 billion
• Book Value per Share
For the purpose of analysis, we divide the book value of equity by the total
number of shares to make the book value per share.

Book value per share represents the firm’s equity on a per-share basis.

This means if the company dissolves, the shareholders will receive an amount per
share as per book value per share.

The formula for book value per share = book value of equity / total number
of outstanding shares

Taking the above example of Apple Inc., we can calculate the book value per
share as follows:

Book Value per Share = US$ 134.05 billion/ 5.126 billion shares = US$ 26.15

Therefore we can say if Apple Inc. dissolves today, shareholders will get US$
26.15 per share.
On the final notes, we can conclude that to interpret
anything from the book value of equity; it is important
that the book value reflects the fair value of its assets
and liabilities.

As an investor or analyst, we must be sure that the

company’s balance sheet that we are analyzing is
marked to market, i.e., reflects the most recent market
price of assets and liabilities.
2. Liquidation Value Method of Equity Valuation
• The liquidation value method of equity valuation is one of
the techniques under Balance Sheet based methods of
valuation, which assumes that the value of the company
under this method will be its salvage value if the company is
shut down.
• The net worth or book value of the company reflects its
accounting value, while the liquidation value tends to arrive
at the company’s residual value, assuming that the
company sells off all its assets (at market realizable value)
and pays off all the liabilities that it has taken.
Example Comparing Book Value V/S Adjusted Book Value V/S
Liquidation Value

Sample Balance Sheet

• Liquidity value may slightly differ from the adjusted book value, given the fact that when a
company goes to sell off its assets, it may receive a lesser value than the market value.
• Inventory might have piled up, and since the business needs to be closed down, inventory
may even fetch a lower value.
• Furthermore, some expenses might be incurred during liquidation, which can also be taken
into account to arrive at a fair liquidation value.
So we deduct this amount of total reduced realization from the
adjusted book value, which comes to

$ 3900 Mio Less $ 290 Mio = $ 3710 Mio.

Liquidation Value Method of Equity Valuation
 Liquidation Value Method Uses – An Analyst’s
Perspective
• The liquidation value method can be used for
making investment decisions.
• Suppose the company is profitable and the
industry is growing too.
• In that case, the company’s liquidation value will
normally be much lower than the share price
since the share price factors growth aspect,
which liquidation value does not.
3. Replacement Value Method of Equity Valuation

• The replacement value method considers ‘the amount

required to replace the existing company’ as the
valuation of a company.
• In other words, if one is to create a similar company in
the same industry, all costs required to do so will form
part of the firm’s value. This is also called “Substantial
Value.”
Sample Balance Sheet (Table 1)
Sample Balance Sheet (Table 1)
• In the same case, let us calculate the replacement cost, given the following
assumptions:
1. 20% of the fixed assets are unused.
2. The market value of the assets is 50% higher than the accounting value carried in
the balance sheet.
• The replacement cost adjusted balance sheet will now have fixed assets value as
follows:
Replacement Cost Adjusted Balance Sheet (Table II)
Hence, as per the replacement value method, the
company’s value is $3000 Mio (refer to Table III).
 Different types of substantial value
Types of Substantial Value / Replacement Value
• Gross Substantial Value
It is the total asset value at replacement value which in our example will be $
5400 Mio (see “Table I” assets side total)

• Net Substantial Value

It is the replacement cost value based on the replacement value for the
adjusted balance sheet, which in our example will be $ 3000 Mio (See Table
III)

• Reduced Gross Substantial Value

It is the total asset value less cost-free debt (Here, creditors) which in our
example will be $ 5400 Mio less $ 1200 Mio (creditors) = $ 4200 Mio.
Comparison between Liquidation and Replacement Value
Method
üThe replacement cost method of equity valuation assumes that the
company continues to operate against shutting down of business.
üWhereas the liquidation value method of equity valuation assumes
that the company will be shutting down its business, and hence the
value of the company under this method will be its salvage value.
üIn the case of the replacement cost method, generally,
replacement cost excludes those assets which are not being used
by the company for its daily operations, while in the case of the
liquidation value method, all assets are taken into consideration.
üThe liquidation value method may be prone to distress pricing,
which is not the case with the replacement cost method.
• The replacement value method is the more refined way of
calculating the company’s value; however, it comes with the
drawback of incorrect estimation.
• The use of the replacement value method will be
incomplete if we do not compare it with the Q ratio, which is
also called Tobin’s Q.
• Using the Q ratio based on replacement cost adds value to
the investment decision process.
• The Q ratio, also known as Tobin's Q, measures whether a
firm or an aggregate market is relatively over- or
undervalued.