Equity Value: Definition & Formula

Instructor: Douglas Stockbridge

DJ Stockbridge is currently pursuing a Masters degree in Accounting.

In this lesson, we'll discuss equity value. This is a popular financial metric that measures the value of a company to its shareholders. We'll walk through an example of how to calculate equity value, as well as describe various financial ratios that use it.

Widget Inc.

Let's imagine there is a giant widget-making company, called Widget Inc. (WI). After Widget Inc.'s release of its annual financials this past year, newspapers could have read, ''Widget Inc. continues to grow its equity value - the widget market is close to surpassing the $200B mark.'' Another article might have described how WI is trading at a P/E ratio of 28x. Those words are probably gibberish to you right now. But after this lesson, you'll have a clear grasp of what those sentences are conveying about the company.

In this lesson, we'll unpack the terms mentioned and we'll walk through the calculation of equity value for Widget Inc. for 2016. We'll then conclude with a brief introduction of common financial ratios that use equity value.

Equity Value

Equity value is the total value for the company's shareholders. As you may know, equity value is total assets minus total liabilities. So, put another way, equity value is the residual claim on the company's assets. Shareholders own the assets that are left over after the liabilities (like bonds outstanding) are paid. It is calculated as follows:

Market Value of Equity + Fair Value of Stock Options + Fair Value of Convertible Securities = Equity Value

Let's unpack each part of the equation. The market value of equity, also known as the market capitalization, is the number of shares outstanding multiplied by the market price. This is the easiest part of the equation to calculate.

Stock options are a form of compensation that allow employees to buy shares of the company at a specific price. There are two types of stock options - ''in-the-money'' and ''out-of-the-money.''

''In-the-money'' options are options that allow employees to buy the shares at a lower price than what the shares are currently trading for. For example, if Widget Inc.'s share price is $42, and employees have options that allow them to buy shares at $40, then they have ''in-the-money'' options because they can buy the shares at $40 and immediately sell them at $42, profiting $2 per share.

''Out-of-the-money'' options are options that allow the employees to buy shares at a higher price than what the shares are currently trading for. For example, these options would give the employees the right to buy shares at $50. They would not exercise that option because they could buy shares at a lower price, $42, in the public market.

For the calculation of equity value, we need to account for the stock options that can be exercised today. In other words, we need to account for the value of ''in-the-money'' stock options. In essence, we are pretending that the employees exercise the options and become shareholders today.

And lastly, convertible securities are debt instruments that can be converted into equity. Like ''in-the-money'' options, we need to convert the securities into their equivalent shares to come to a calculation of equity value.

Equity Value for Widget Inc.

Let's walk through an example. We'll calculate Widget Inc.'s equity value for 2016.

Let's assume the market value of equity, or capitalization, is 4.367 billion shares x $42.00/share equals $183B. Let's say shares are currently trading at $42 and the value of ''in-the-money'' stock options is $1.8B. Let's also assume there are no convertible securities, which are quite uncommon. Widget Inc.'s equity value is then $183B + $1.8B + 0 = $184.8 billion.

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