Basic, lesson 1 of 3
Equity value and diluted shares
Equity value is what the shares are worth. The only hard part is counting the shares correctly, and that is exactly what interviewers test.
9 min, 2 checks
1What equity value measures
Equity value is the value of a company that belongs to its shareholders. For a public company you can read it straight off the market: multiply the share price by the number of shares. That product is market capitalization, usually shortened to market cap.
Think of it as the price tag on the ownership stake alone. If you bought every share, you would own the company, but you would also inherit its debt and its cash. Equity value ignores both. That is the whole reason a second number, enterprise value, exists.
Equity value = share price x diluted shares outstanding
The word diluted matters. Basic shares are the shares that exist today. Diluted shares add the shares that would exist if people holding options, warrants, restricted stock, and in the money convertibles turned them into stock. Bankers always use diluted shares, because a buyer has to pay those holders too.
2The treasury stock method
Options give an employee the right to buy a share at a fixed strike price. If the share trades above the strike, the option is in the money and will be exercised. If it trades below, nobody exercises it, and it adds nothing.
When options are exercised, the company receives the strike price in cash. The treasury stock method assumes the company uses that cash to buy back shares at today's price. So the net new shares are the options exercised minus the shares repurchased.
Net new shares = options in the money - (options x strike price) / share price
Worked example
Diluting a $20 stock
- 1Share price $20, basic shares 100m, options outstanding 10m with a strike of $10.
- 2The options are in the money ($20 is above $10), so all 10m are exercised.
- 3Cash received: 10m x $10 = $100m.
- 4Shares repurchased at $20: $100m / $20 = 5m.
- 5Net new shares: 10m - 5m = 5m. Diluted shares: 100m + 5m = 105m.
- 6Equity value: 105m x $20 = $2,100m.
Diluted shares 105m, equity value $2,100m. Using basic shares would have understated it by $100m.
Check 1
Share price $50, basic shares 200m, options 8m with a strike of $30. Diluted shares, in millions?
3What counts and what does not
| Instrument | How it enters |
|---|---|
| Options and warrants in the money | Treasury stock method |
| Options and warrants out of the money | Ignored |
| Restricted stock units | Added in full, no strike to receive |
| Convertible bonds in the money | Shares from conversion, bond leaves debt |
Restricted stock units have no strike price, so the company receives nothing when they vest. They add one share each. Out of the money options are left out because a rational holder would not pay more than the market price for a share.
Check 2
A stock trades at $15. Employees hold 4m options with a strike of $18. How many shares do the options add?
Terms in this lesson: Equity value, Enterprise value, Treasury stock method.
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