What should you subtract out to get to equity value?

            The general rule that you should use is that the debt you subtract from the value of the firm should be at least equal to the debt that you use to compute the cost of capital. Thus, if you decide to capitalize operating leases as debt, as we did with the Gap in the last chapter, to compute the cost of capital, you should subtract out the debt value of operating leases from the value of operating assets to estimate the value of equity. If the firm you are valuing has preferred stock, you would use the market value of the stock (if it is traded) or estimate a market value[1] (if it is not) and deduct it from firm value to get to the value of common equity.

            There may be other claims on the firm that do not show up in debt that you should subtract out from firm value.

            As you forecast earnings growth for your firm, you generally also assume that the firm will increase its debt as it grows. A question that arises then is whether you should be subtracting out the value of these future debt issues when estimating equity value today. The answer is no, since the value of the equity is a current value and these future claims do not exist today. To illustrate, assume that you have a firm with no debt today and that you assume that it will have a 30% debt ratio in stable growth. Assume further that your estimate of the terminal value for this firm is $10 billion in 5 years. You are implicitly assuming that your firm will borrow $3 billion in 5 years to raise its debt ratio to 30%. This higher debt ratio may affect your firm value today, but the value of equity today is the firm value less the current debt.


[1] Estimating market value for preferred stock is relatively simple. Preferred stock generally is perpetual and the estimated market value of the preferred stock is therefore:

Value of preferred stock

The cost of preferred stock should be higher than the pre-tax cost of debt, since debt has a prior claim on the cash flows and assets of the firm.