Enterprise Value to Equity Value Per Share: DCF Model

Let’s talk about how we find the equity value per share when we’ve already calculated the enterprise value using a Discounted Free Cash Flow model, often called DCF. It might sound a bit complicated, but it’s really a process of peeling back layers to get to what we’re truly interested in: the value for each individual share of stock.

Imagine a whole pizza. The enterprise value, calculated through the DCF model, is like the value of the entire pizza pie. The DCF model helps us estimate the total worth of a company’s operations, considering all its future cash flows, just like estimating the total deliciousness and worth of that entire pizza based on its ingredients and baking process.

The DCF model works by projecting a company’s free cash flows into the future. Think of free cash flow as the cash a company generates that’s actually available to its investors after it has paid for all the things needed to keep the business running and growing, like ingredients for our pizza analogy. These future cash flows are then ‘discounted’ back to today’s value. Discounting is essentially the reverse of compounding interest. It acknowledges that money today is worth more than the same amount of money in the future because of factors like inflation and the potential to earn interest. So, by discounting these projected future cash flows, we arrive at the enterprise value, representing the total value of the company’s core business operations.

Now, enterprise value is great, but it represents the value of the entire company, including all its debt and equity. Think of our pizza again. The enterprise value is the price of the whole pizza, but we, as potential shareholders, are only interested in our slice of that pizza, the equity part. Equity value, on the other hand, represents the value that belongs specifically to the shareholders, the owners of the company.

To get from the enterprise value, the whole pizza price, to the equity value, our slice price, we need to make a few adjustments. The key adjustment is to account for debt. Companies often use debt to finance their operations. Debt is a claim against the company’s assets that ranks before equity. So, if we think of the enterprise value as the total value available to all investors, both debt holders and equity holders, we need to subtract the value attributable to debt holders to find what’s left for equity holders.

Therefore, the first major step is to subtract net debt from the enterprise value. Net debt isn’t simply the total debt a company has. It’s usually calculated as total debt minus cash and cash equivalents. Why subtract cash? Because cash is an asset that can be used to pay off debt. So, if a company has a lot of cash, its ‘net’ debt burden is actually lower. Imagine our pizza company has some cash in its till. That cash isn’t really part of the operating value of the pizza business itself; it’s extra. We can use that cash to reduce the company’s obligations, like debt.

After subtracting net debt from enterprise value, we arrive at the equity value. This represents the total value of the company that belongs to the shareholders. It’s like the price of our slice of the pizza after accounting for any loans taken out to make the pizza.

But we’re not quite done yet. We want equity value per share. Equity value is the total value of all outstanding shares combined. To find the value of a single share, we simply divide the total equity value by the number of shares outstanding. Shares outstanding are the total number of shares of stock that have been issued by the company and are currently held by investors.

So, if our calculated equity value is, say, one billion dollars, and the company has one hundred million shares outstanding, then the equity value per share would be one billion dollars divided by one hundred million shares, which equals ten dollars per share.

In summary, to get from enterprise value to equity value per share using the DCF model:

First, we calculate the enterprise value using the Discounted Free Cash Flow model. This is the total value of the company’s operations.

Second, we subtract net debt from the enterprise value. Net debt is typically total debt minus cash and cash equivalents. This gives us the total equity value.

Third, we divide the total equity value by the number of shares outstanding. This gives us the equity value per share, which is the estimated intrinsic value of a single share of the company’s stock.

This equity value per share is what analysts and investors often compare to the current market price of the stock to determine if a stock might be undervalued or overvalued. It’s a crucial step in using the DCF model to make informed investment decisions.