Question

What model is used to compute the value of the equity?

Answer 1

To compute the value of equity the discounted cash flow model or the multiples valuation model are generally used.

In the discounted cash flow model levered free cash flows are computed and projected for future years. The levered cash flows are then discounted by the cost of equity. The alternative method is to use the unlevered free cash flows and discount them by weighted average cost of capital. This gives us the enterprise value. We can compute the value of equity using the following formula in this case: Equity value = Enterprise value – debt – preferred stock+cash and equivalents.

Another method to compute value of equity is the multiples valuation model. In this model metrics like EV/Sales, EV/EBITDA, EV/EBIT, P/E ratio etc are used for a company and this is compared with the same metrics of its competitors. The average and median of each metric is computed for all the companies and on this basis the appropriate price per share is determined for the concerned company. Equity value is then computed using the formula: Equity value = share price*number of shares outstanding