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Equity Valuation: Definition & Process

Instructor: Usha Bhakuni

Usha has taught high school level Math and has master's degree in Finance

This lesson includes an overview of equity valuation process. You will learn about the basic steps to follow to find the fair value of a company's equity shares.

Equity Valuation

Suppose you invest in the equity shares of a company at $10/share. How do you know this is a fair price? To ascertain the fair value of a company's equity, the process of equity valuation is utilized in financial markets. Fair value is an estimate of what a company is truly worth.

The market price of the equity shares is the price at which they are sold in the stock exchange. This may or may not be equal to the fair value. The difference between the fair value and its market price is the perceived mispricing and occurs mainly because each investor has a different perception of the same company. To understand this mispricing, one needs to master the art of equity valuation.

Two categories of methods are used to find the value of equity shares:

  • Absolute value: These methods involve forecasting the future financials of the company and finding the present value.
  • Relative value: In these methods, the value is found by comparing the company's financials with its peers (similar companies), and then building an estimate based on their values.

Process of Equity Valuation

Different investors use different methods for estimating equity valuation, but the basic process remains more or less the same. There are 5 general steps that are usually followed. We will understand each of the steps with the help of an example.

Suppose you are a resident of the USA and want to invest in a multinational company called ABC. ABC is in the automobile industry. It is based in and does the majority of its business in Europe. The shares are trading at a price of $15/share in the US stock exchanges. To ascertain the fair value of this company, you're required to adhere to the following process:

1. Understanding the Business

No company works in a silo. A company's performance depends on a variety of external factors. The first step in an equity valuation is usually a top-down research on macroeconomic and industry factors that impact the company.

For investing in ABC, you need to understand the macroeconomic and geopolitical scenario in Europe where the company does the majority of its business - inflation, interest rates, risks, etc. Then, you need to be aware of the dynamics of the industry - its major players, growth and performance parameters, future projections, etc. Finally, you need to understand the business of the company - its products, future strategy, market share, customers, etc. This research will help you understand the type of market in which ABC is operating and give you an idea of parameters that are important for valuation.

2. Forecasting the Company's Performance

Based on the analysis of the industry and macroeconomic factors, you can make a reasonable forecast of the company's future financial performance - revenues, income, costs, etc.

For ABC company, you need to forecast the future production, changes in its cost structures, sales, etc. to arrive at a reasonable estimate of how the company will perform in the future. You must also include any major investments that the company is planning to make and changes in strategy. This requires a deep understanding of the company's business.

3. Selecting Appropriate Valuation Model

There are several valuation models available. All of them need not give the same valuation for a company's equity. It depends on the analyst and the investor. Using the data available and his/her knowledge, the analyst makes a choice of what type of valuation model would be most suited. Often, the analysts calculate value with numerous models and then arrive at an estimated range of valuation.

For the company ABC, if the future forecasts sufficiently align with your information, you can use absolute valuation models to determine the value. Also, you can estimate the valuation for the peers of the company and estimate its value using relative valuation techniques.

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