Question

Is value of equity the sum of discounted future cash flows to equity?

And when computing the ROE and ROC should I use market value of the equity or book value of equity?

Can someone give me answers in a bit details?

Answer 1

Value of equity generally refers to market price of the share.

If a person wants to invest in a particular stock, he first tries to findout whether the stock is underpriced or overpriced i.e. what should be the fairvalue of the equity. This is found out by calculating the sum of discounted future cash flows of that share. Therefore, if the fairvalue is more than market price, then the share is said to be underpriced and the decision shall be to buy it. If the fairvalue is lower than the market price, then the stock is overpriced and the person should decide not to buy it.

ROE is return on equity, its formula is Net Income / Shareholder's equity. Here Shareholder's equity means Commonshare capital and Retained earnings. However, we use bookvalues to calculate ROE and not market values. It is because Net Income is calculated as per accounting principles and GAAP. As a result, we should use balancesheet figures (Bookvalues) of equity to match the same.

ROC is Return on capital employed. its formula is Net Income / Total capital employed. Total capital employed includes Share capital (Common and Preference), Retained Earnings and long term debt financed. Even in this case, we use book values to calculate the ratio. The reason being same as the above.