Companies obtain capital from two sources, including equity and debt. Equity is the finance that comes from a company’s shareholders. Usually, this equity is in the form of shares or preferred stocks. These shares may also come with voting rights. Debt, on the other hand, is finance received from third parties. It usually carries an obligation to pay regular interest. However, they don’t hold any voting rights.
Both equity and debt are crucial for a company’s long-term success. Companies seek to strike a balance between both sources of finance to achieve the best results. However, equity is usually more prominent for most companies. Similarly, equity finance is more easily available compared to debt. It can also help investors evaluate a company’s value through the market value of equity. Before understanding it, however, it is crucial to discuss equity.
What is Equity?
Equity represents any value that is attributable to a company or business owner. In accounting, it is the residual amount after deducting a company’s liabilities from its assets. Assets represent all resources owned or controlled by a company that can result in future cash inflows. Liabilities are obligations that give rise to economic outflows in the future.
By deducting a company’s liabilities from its assets, investors can get the value that is their right. It also describes the value that investors will receive if a company liquidates. However, this definition represents the book value of equity or its accounting value. It does not necessarily mean investors will only get the residual amount. In practice, this amount may be higher or lower than what investors actually get.
There are three basic types of equity that companies may accumulate. The first is its common stock, which is the value of the total number of its outstanding shares. However, it only represents the par value of those shares. Similarly, it may not be equal to the actual finance that companies receive from their shareholders. Common stock is the most prevalent type of equity that companies will have.
Companies also accumulate preferred stocks as a part of their equity. Preferred stock refers to any shares that companies issue that get preference over common stock. However, these stocks do not carry any voting rights. Lastly, companies also may have warrants as equity. These are options added to debt or preferred stock to allow their holders to convert them into common stock.
What is the Market Value of Equity?
The book value of equity refers to the residual amount after deducting a company’s liabilities from its assets. However, it does not represent the market value of equity. It refers to a company’s equity value set by the market. In other words, it is the total dollar value of its equity based on the market’s perception.
Another name used for the market value of equity is market capitalization. It measures a company’s value through the product of its total outstanding number of shares and its share market price. For companies, the total outstanding number of shares does not change regularly. However, the share market prices fluctuate based on the market’s perception of the company’s value.
Therefore, the market value of equity is an unstable analysis of a company’s value. Nonetheless, it provides investors with critical information about how much the market values the company. Through this value, investors can measure the size of a company according to its shares. Based on this information, investors can diversify their investments into companies of different sizes and risks.
It represents a company’s value in market terms. However, it is not the value as per the company’s records. Instead, it refers to a company’s evaluation based on the market’s perception. For larger companies, this value will be significantly higher than smaller companies. These companies also have a more stable market value of equity.
How to calculate the Market Value of Equity?
The formula is the same as market capitalization. Investors can calculate a company’s market value of equity by the definition of the term. As mentioned, it is the product of a company’s outstanding number of shares and its share’s market price. Therefore, its formula will be as follows.
Market Value of Equity = Total Outstanding Number of Shares x Share Price in the Market
The total outstanding number of a company’s shares is available in its financial statements. Investors can get this value through a company’s balance sheet or its notes to the financial statements. For newer companies, this value may frequently change due to regular share issuance. For larger companies, the total outstanding number of shares remains stable.
The primary instability of the market value of equity comes from a company’s market share price. For private companies, this price may not differ a lot. However, for public companies, it fluctuates frequently. Investors can also take an average of a company’s share prices in the market over time. However, the formula usually requires the latest price.
Example
A company, ABC Co., had a total outstanding number of shares of 100,000. These shares have a par value of $10 per share. Therefore, the company’s book value of equity was $1,000,000 (100,000 share x $10 per share). ABC Co.’s share price in the market, however, was $20 per share. Therefore, the company’s market value of equity will be as follows.
Market Value of Equity = Total Outstanding Number of Shares x Share Price in the Market
Market Value of Equity = 100,000 shares x $20 per share
Therefore, Market Value of Equity = $2,000,000
As per the above calculation, ABC Co.’s market capitalization is $2 million. This value differs from the amount the company will report on its balance sheet, valued at $1 million. On its own, the market value equity does not provide critical information about a company. However, investors can use it comparatively for a better analysis.
Another company, XYZ Co., had a total outstanding number of shares of 500,000 with a par value of $10. Therefore, the company’s book value of equity was $5,000,000 (500,000 shares x $10 per share). XYZ Co.’s share prices were worth significantly more in the market than ABC Co. at $50 per share. Therefore, XYZ Co.’s market value of equity will be as follows.
Market Value of Equity = Total Outstanding Number of Shares x Share Price in the Market
Market Value of Equity = 500,000 shares x $50 per share
Therefore, Market Value of Equity = $25,000,000
XYZ Co.’s market value of equity is significantly higher compared to ABC Co. Despite having the same par value, two factors influenced the higher market value of equity. These include the higher number of outstanding shares and the higher market value of its shares. In terms of comparison, XYZ Co. is a larger company compared to ABC Co.
Why is the Market Value of Equity important?
It is important for several reasons. Firstly, it helps investors evaluate a company based on the open market. It demonstrates what a company is worth to investors. By doing so, it allows investors to make a decision about investing in the company. Similarly, it provides investors with an indication of a company’s size and its operations.
It also helps investors diversify their portfolios with investments of different sizes and risks. Usually, investors classify companies based on their market value. For example, a company having a market value of equity of $300 million up to $3 billion falls in the small-cap category. These investments provide higher returns but may pay lower dividends. Therefore, it helps investors with their portfolios.
The market value of equity is also a global method to evaluate a company. The formula is straightforward to use, which makes it easier for investors to make calculations. It is also easy to understand for investors since the same concept applies to all stock markets. This way, investors can also make better comparisons between companies from different markets.
Overall, it is an accurate depiction of a company’s market worth. While this value may fluctuate often, it still helps investors in surveying the market. Investors also use it to balance their portfolios for risks. Usually, companies with a higher market value of equity carry lower risks than those with a smaller amount.
Conclusion
The market value of equity is a term used to describe a company’s value based on market perception. It is the product of a company’s market share price and its total outstanding number of shares. It is one of the critical metrics for investors. There are several reasons why the market value of equity is important, some of which are available above.
