Equity value simplified

Warren Buffet always speaks pearls of wisdom, and if understood and followed, the words could do wonders. On one such occasion, the mighty investor said, “Buy into a business that’s doing so well an idiot could run it, because sooner or later, one will.”

This one statement aptly explains the meaning of “equity value”. If financial definitions are to be considered, then equity value is the overall value of a stock of a business, which is the present value of all the future profits. With start – ups, however, the future is more uncertain and this leads to a great variation in valuation.

All profits margins tend to go towards zero in perfectly competitive markets. This makes equity dependent on the degree to which you can make your market inefficient by making your business almost impossible to copy. This is also called defensibility. If having superior people is the sole support for your defensibility, then what you have is called a service business by Venture Capitalists. Such businesses have low margins in competitive labor markets, and also have low equity value. People usually say that for service businesses, the equity value walks out of the door every night.

Every type of technology business shows a different relationship between its revenue, capital, equity value, and profits. Enterprise software companies usually require a lot of capital to get to scale, and once they do, they usually have a very high equity value. This is partly because such companies are averse to risk and also adopt technology that is most popular, which eventually leads to a winner – take – all dynamic.

The value of the equities of consumer internet companies varies to a great extent. It depends on their defensibility, and the business model. Biotech companies, on the other hand, need truckloads of capital for Research and Development and approval from regulatory authorities. They, however, are able to generate a lot of equity value and their defensibility primarily comes from the patents they file. E – commerce companies, too, require a lot of capital. This is because their defensibility comes from brand and the economies of sale.