Shareholders Equity and Book Value
Assist in determining stock fair valuece
Shareholders equity is the capital invested from shareholders and from retained profits, that is, profits not distributed as dividends.
It is measured by adding share capital, reserves, retained profits and minority interest.
It is equivalent to book value except that book value is more often expressed as the 'per share' value by dividing the shareholders equity by the number of shares on issue.
Book value and (shareholders) equity per share mean the same thing and they may be used as a starting point to estimate stock fair value.
If a company pays out all its profits (payout ratio = 100%) and the company's return on equity (ROE) is the same as the investor's required return (RR) on the investment, then the equity per share (or book value) represents fair value.
Stock Fair Value = Equity per share if ROE = RR
Accounting for Retained Profits
In practice, some profits are usually retained, and the return on equity (ROE) is often different (greater or less) than the required return of the investor.
Smart investors require that the ROE is greater than the RR, and the greater the better.
A formula derived by Brian McNiven and described in his book Market Wise takes the situation where some profits are re-invested into account.
His formula ensures that the greater the proportion of retained earnings that are re-invested at a rate that exceeds the required return (RR), the more desirable the stock and hence the higher the value.
For this reason, one would not only look for companies that have a high return on equity (>15%), but also favor those that re-invest most if not all of their profits in the company. Why? - the investor would be flat out achieving the same return elsewhere.
McNiven's formula involves simple arithmetic and is in line with Buffet's comment that simple arithmetic is all that you need to value stocks.
So for investors following a value investing approach like me, equity per share is an important financial starting point to the determination of the stock fair value of a company.
Return from Shareholders Equity to Financial Ratios
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