littlebookThe Little Book of Valuation

Getting to equity value per share

            We have covered the four inputs that go into discounted cash flow valuation models – cash flows, discount rates, growth rates and the terminal value. The present value we arrive at, when we discount the cash flows at the risk-adjusted rates should yield an estimate of value, but getting from that number to what we would be willing to pay per share for equity does require use to consider a few other factors.

a.     Cash and Marketable Securities: Most companies have cash balances that are not insignificant in magnitude. Is this cash balance already incorporated into the present value? The answer depends upon how we estimated cash flows. If the cash flows are based on operating income (free cash flow to the firm) or non-cash net income, we have not valued cash yet and it should be added on to the present value. If, on the other hand, we estimate cash flows from the cumulative net income or use the dividend discount model, cash already has been implicitly valued; the income from cash is part of the final cash flow and the discount rate presumably has been adjusted to reflect the presence of cash

b.     Cross Holdings in other companies: Companies sometimes invest in other firms, and these cross holdings can generally be categorized as either minority or majority holdings. With the former, the holdings are usually less than 50%, and the income from the holdings are reported in the income statement below the operating income line. If we use free cash flow to the firm to value the operating assets, we have not valued these minority holdings yet, and they have to be valued explicitly and added to present value. With majority holdings, which generally exceed 50%, firms usually consolidate the entire subsidiary in their financials, and report 100% of the operating income and assets of the subsidiary. To reflect the portion of the subsidiary that does not belong to them, they report the book value of that portion as minority interest in a balance sheet. If we compute cash flows from consolidated financial statements, we have to subtract out the estimated market value of the minority interest.

c.     Potential liabilities (not treated as debt): Since we are interested in the value of equity in the firm, we have to consider any potential liabilities that we may face that reduce that value. Thus, items like under funded pension obligations and health care obligations may not meet the threshold to be categorized as debt for cost of capital purposes but should be considered when valuing equity. In other words, we would subtract out the values of these and other claims (such as potential costs from lawsuits against the firm) on equity from firm value to arrive at equity value.

d.     Employee Options: Having arrived at the value of equity in the firm, there is one final estimate that we have to make, especially if the firm has made it a practice to grant options to managers. Since many of these options will be still outstanding, we have to consider them as another (and different) claim on equity. While analysts often use short cuts (such as adjusting the number of shares for dilution) to deal with these options, the right approach is to value the options (using an option pricing model), reduce the value of equity by the option value and then divide by the actual number of shares outstanding.

Table 2.9 summarizes the loose ends and how to deal with them in the different models.

Table 2.9: Dealing with loose ends in valuation

Loose End

Dividend Discount Model

FCFE Model

FCFF Model

Cash and Marketable Securities

Ignore, since net income includes interest income from cash.

Ignore, if FCFE is computed using total net income. Add, if FCFE is computed using non-cash net income

Add. Operating income does not include income from cash.

Cross Holdings

Ignore, since net income includes income from cross holdings.

Ignore, since net income includes income from cross holdings.

Add market value of minority holdings and subtract market value of minority interests.

Other Liabilities

Ignore. The assumption is that the firm is considering costs when setting dividends.

Subtract out expected litigation costs.

Subtract out under funded pension obligations, health care obligations and expected litigation costs.

Employee options


Subtract out value of equity options outstanding

Subtract out value of equity options outstanding