Reinvesting earnings increases the book value of equity?
The book value is Total Assets minus Total Liabilities and so if you increase the Total Assets without changing the Total Liabilities the difference gets bigger and thus higher. Consider if a company had total assets of $4 and total liabilities of $3 so the book value is $1. Now, if the company adds $2 to the assets, then the difference would be 4+2-3=6-3=3 and last time I checked 3 is greater than 1. On definitions, here are a couple of links to clarify that side of things. From Investopedia: Equity = Assets - Liabilities From Ready Ratios: Shareholders Equity = Total Assets – Total Liabilities OR Shareholders Equity = Share Capital + Retained Earnings – Treasury   Shares Depending on what the reinvestment bought, there could be several possible outcomes. If the company bought assets that appreciated in value then that would increase the equity. If the company used that money to increase sales by expanding the marketing department then the future calculations could be a bit trickier and depend on what assumptions one wants to make really. If you need an example of the latter, imagine playing a game where I get to make up the rules and change them at will. Do you think you'd win at some point? It would depend on how I want the game to go and thus isn't something that you could definitively say one way or the other.
However what actually appears to happen is that the 100k is invested into the company to fund some growth plan. So is it actually the case that E's company is worth 400k only AFTER the transaction? Is the 100k added to the balance sheet as cash and would the other 300k be listed as an IP asset? The investor gets 25% of the shares of the company and pays $100k for them, so Owner's Equity increases by $100k, and the company gets $100k more in cash. The $400k number is an implicit calculation: if 25% of the company is worth $100k, 100% of the company is worth $400k. It's not on the books: the investor is just commenting that they feel that they are being over-charged. I have heard that people say the greater earning means greater   intrinsic value of the company. Then, the stock price is largely based   on the intrinsic value. So increasing intrinsic value due to   increasing earning will lead to increasing stock price. Does this make   sense ? Yes though it may be worth dissecting portions here. As a company generates earnings, it has various choices for what it can do with that money. It can distribute some to shareholders in the form of dividends or re-invest to generate more earnings. What you're discussing in the first part is those earnings that could be used to increase the perceived value of the company. However, there can be more than a few interpretations of how to compute a company's intrinsic value and this is how one can have opinions ranging from companies being overvalued to undervalued overall. Of Mines, Forests, and Impatience would be an article giving examples that make things a bit more complex. Consider how would you evaluate a mine, a forest or a farm where each gives a different structure to the cash flow? This could be useful in running the numbers here. "A bit strange but okay.  The way I would think about this is again that you need to determine for what purpose you're computing this, in much the same way you would if you were to build out the model. The IPO valuation is not going to be relevant to the accretion/dilution analysis unless you're trying to determine whether the transaction was net accretive at exit. But that's a weird analysis to do. For longer holding periods like that you're more likely to look at IRR, not EPS. EPS is something investors look at over the short to medium term to get a sense of whether the company is making good acquisition decisions. And to do that short-to-medium term analysis, they look at earnings.   Damodaran would say this is a shitty way of looking at things and that you should probably be looking at some measure of ROIC instead, and I tend to agree, but I don't get paid to think like an investor, I get paid to sell shit to them (if only in indirect fashion). The short answer to your question is that no, you should not incorporate what you are calling liquidation value when determining accretion/dilution, but only because the market typically computes accretion/dilution on a 3-year basis tops. I've never put together a book or seen a press release in my admittedly short time in finance that says ""the transaction is estimated to be X% accretive within 4 years"" - that just seems like an absurd timeline.  Final point is just that from an accounting perspective, a gain on a sale of an asset is not going to get booked in either EBITDA or OCF, so just mechanically there's no way for the IPO value to flow into your accretion/dilution analysis there, even if you are looking at EBITDA/shares. You could figure the gain on sale into some kind of adjusted EBITDA/shares version of EPS, but this is neither something I've ever seen nor something that really makes sense in the context of using EPS as a standardized metric across the market. Typically we take OUT non-recurring shit in EPS, we don't add it in. Adding something like this in would be much more appropriate to measuring the success of an acquisition/investing vehicle like a private equity fund, not a standalone operating company that reports operational earnings in addition to cash flow from investing. And as I suggest above, that's an analysis for which the IRR metric is more ideally situated.  And just a semantic thing - we typically wouldn't call the exit value a ""liquidation value"". That term is usually reserved for dissolution of a corporate entity and selling off its physical or intangible assets in piecemeal fashion (i.e. not accounting for operational synergies across the business). IPO value is actually just going to be a measure of market value of equity." No, I think you are misunderstanding the Math. Stock splits are a way to control relatively where the price per share can be for a company as companies can split or reverse split shares which would be similar to taking dimes and giving 2 nickels for each dime, each is 10 cents but the number of coins has varied. This doesn't create any additional value since it is still 10 cents whether it is 1 dime or 2 nickels.  Share repurchase programs though are done to prevent dilution as executives and those with incentive-stock options may get shares in the company that increase the number of outstanding shares that would be something to note. Conservative = erring on the side of ascribing a higher EV to the business. Because if you're someone looking to acquire the business, for example, and let's say we're talking about a business that has debt which trades at a discount, it's more conservative to assume that the debt can't necessarily be restructured.  To use an extreme example, as you're valuing the business, would it be conservative or aggressive to assume that the debt got magically wiped out altogether? So that's why I'm saying that it's more conservative to use the book value of the debt. Expense accounts are closed into equity.  Same with revenue.   So an increase in an expense means lower equity (lower retained earnings since there is more expense). Ergo, decrease equity and increase a liability. Increase a liability since it was accrued, which is usually used specifically to refer to things that kind of just happen in the background. Aka the firm most likely didn't pay cash for that right then and there so increase a payable. And the kind folk at Yahoo Finance came to the same conclusion.  Keep in mind, book value for a company is like looking at my book value, all assets and liabilities, which is certainly important, but it ignores my earnings.  BAC (Bank of America) has a book value of $20, but trades at $8. Some High Tech companies have negative book values, but are turning an ongoing profit, and trade for real money. Shareholder's Equity consists of two main things: The initial capitalization of the company (when the shares were first sold, plus extra share issues) and retained earnings, which is the amount of money the company has made over and above capitalization, which has not been re-distributed back to shareholders. So yes, it is the firm's total equity financing-- the initial capitalization is the equity that was put into the company when it was founded plus subsequent increases in equity due to share issues, and retained earnings is the increase in equity that has occurred since then which has not yet been re-distributed to shareholders (though it belongs to them, as the residual claimants). Both accounts are credited when they increase, because they represent an increase in cash, that is debited, so in order to make credits = debits they must be credits. (It doesn't mean that the company has that much cash on hand, as the cash will likely be re-invested). Shareholder's Equity is neither an asset nor a liability: it is used to purchase assets and to reduce liabilities, and is simply a measure of assets minus liabilities that is necessary to make the accounting equation balance: Since the book value of stocks doesn't change that often (because it represents the price the company sold it for, not the current value on the stock market, and would therefore only change when there were new share issues), almost all changes in total assets or in total liabilities are reflected in Retained Earnings. The Gordon equation does not use inflation-adjusted numbers. It uses nominal returns/dividends and growth rates. It really says nothing anyone would not already know.  Everyone knows that your total return equals the sum of the income return plus capital gains.   Gordon simply assumes (perfectly validly) that capital gains will be driven by the growth of earnings, and that the dividends paid will likewise increase at the same rate. So he used the 'dividend growth rate' as a proxy for the 'earnings growth rate' or 'capital gains rate'. You cannot use inflation-removed estimates of equity rates of return because those returns do not change with inflation.  If anything they move in opposite directions.  Eg in the 1970's inflation the high market rates caused people to discount equity values at larger rates --- driving their values down -- creating losses. "Re. question 2 If I buy 20 shares every year, how do I get proper IRR? ... (I would   have multiple purchase dates) Use the money-weighted return calculation: http://en.wikipedia.org/wiki/Rate_of_return#Internal_rate_of_return  where t is the fraction of the time period and Ct is the cash flow at that time period. For the treatment of dividends, if they are reinvested then there should not be an external cash flow for the dividend.  They are included in the final value and the return is termed ""total return"".  If the dividends are taken in cash, the return based on the final value is ""net return"". The money-weighted return for question 2, with reinvested dividends, can be found by solving for r, the rate for the whole 431 day period, in the NPV summation. Now annualising And in Excel" There are not always capital-efficient ways for a company to reinvest its own profits. This is why dividends exist.  Imagine a company will reinvest 80% of its profits into a project with a huge projected return, but the other 20% of the company's profits cannot be reinvested efficiently because there are zero projects in which to reinvest the profits into that would return a better profit than what the company's shareholders could make by reinvesting those profits in their own way (ie: a benchmark market index like an S&amp;P 500 index fund).  Since the shareholders could make a better return with this than the company could with any company project, it would be irresponsible (technically maybe even illegal) for the company to reinvest that 20% of the profits.  This reason for companies sometimes paying out profits to shareholders in the form of dividends is a market-efficient part of the economic system, and it really is great.  If a CEO/CFO/anyone is paying out so much profit from a company that it is irresponsible to the company's investors, then that would also technically be illegal since the company is evading efficient project that would benefit its shareholders more than they could benefit themselves elsewhere in the market.  (These legalities with shareholder laws are not explicitly put into action very often, but their effects are always there)   It's also worth noting payout/plowback strategy is very important for the strategy and financing of a company, particularly for public investments. I've spent enough time researching this question where I feel  comfortable enough providing an answer.  I'll start with the high level fundamentals and work my way down to the specific question that I had. So point #5 is really the starting point for my answer. We want to find companies that are investing their money.  A good company should be reinvesting most of its excess assets so that it can make more money off of them. If a company has too much working capital, then it is not being efficiently reinvested.  That explains why excess working capital can have a negative impact on Return on Capital. But what about the fact that current liabilities in excess of current assets has a positive impact on the Return on Capital calculation?  That is a problem, period.  If current liabilities exceed current assets then the company may have a hard time meeting their short term financial obligations. This could mean borrowing more money, or it could mean something worse - like bankruptcy.  If the company borrows money, then it will have to repay it in the future at higher costs.  This approach could be fine if the company can invest money at a rate of return exceeding the cost of their debt, but to favor debt in the Return on Capital calculation is wrong. That scenario would skew the metric. The company has to overcome this debt. Anyways, this is my understanding, as the amateur investor. My credibility is not even comparable to Greenblatt's credibility, so I have no business calling any part of his calculation wrong. But, in defense of my explanation, Greenblatt doesn't get into these gritty details so I don't know that he allowed current liabilities in excess of current assets to have a positive impact on his Return on Capital calculation. "Dividends can also be automatically reinvested in your stock holding through a DRIP plan (see the wikipedia link for further details, wiki_DRIP). Rather than receiving the dividend money, you ""buy"" additional stock shares your with dividend money. The value in the DRIP strategy is twofold. 1) your number of shares increases without paying transaction fees, 2) you increase the value of your holding by increasing number of shares. In the end, the RIO can be quite substantial due to the law of compounding interest (though here in the form of dividends). Talk with your broker (brokerage service provider) to enroll your dividend receiving stocks in a DRIP." "Since doodle77 handled arbitrage, I'll take goodwill.  Goodwill is an accounting term that acts much like a ""plug"" account: you add/subtract to it the amount that makes everything balance.  In the case of goodwill, it generally only applies to mergers &amp; acquisitions.  The theory (and justification) is this: firms buy other firms at prices other than the market price (usually higher), and it is assumed that this is because the acquirer values its acquisition more than other people do.  But whether you use historical prices or market prices when you add (subtract) assets and liabilities to to (from) your balance sheet, this will never add up, because you paid more (less) than the assets are worth in the market, so more (less) cash flowed out than assets flowed in.  The difference goes into the goodwill account, so firms with a large goodwill account are ones that have made lots of acquisitions." "Yes - this is exactly what it means.  No losses (negative earnings).   With today's accounting methods, you might want to determine whether you view earnings including or excluding extraordinary items.   For example, a company might take a once-off charge to its earnings when revising the value of a major asset.  This would show in the ""including"" but not in the ""excluding"" figure.   The book actually has a nice discussion in Chapter 12 ""Things to Consider About Per-Share Earnings"" which considers several additional variables to consider here too. Note that this earnings metric is different from ""Stock Selection for the Defensive Investor"" which requires 10 years. PS - My edition (4th edition hardback) doesn't have 386 pages so your reference isn't correct for that edition.  I found it on page 209 in Chapter 15 ""Stock Selection for the Enterprising Investor""."