Anh Hoang

Enterprise Value or Market Capitalization?

September 08, 2011

Value investors consider buying a stock as buying a piece of the business. That is why we often start looking into the company as a whole, to determine what the real value to the private owner of the business is, or the price at which it can be taken over by another company. Then we look deeper in the per share basis to determine the level of dilution or shares buyback impact.

Buying stock is really like buying a piece of the business. Whether an investor buys one share, or the entire company, the investor would have ownership of the company’s assets, debt and earning stream. When talking about the company, a lot of investors often believe that market capitalization is simply the equation of number of shares outstanding multiply the share price. However, it doesn’t fully reflect the level of capitalization in the company, the financial strength as well as the real facts.

Below is a simple example for the two companies, A and B, working in the same industry and with the same market capitalization and the same net income:

 USD million A B Cash 50 100 Total Debt 200 10 Market Capitalization 100 100 Enterprise value 250 10 Net income 10 10

As we can see from above, A and B have the same market capitalization, and the same net income. If the P/E is assigned for both companies, relative valuation would be 10 for both companies, and the earnings yield would be 10% for both as well.

However, if we are the investor and would like to buy out company A, we would have to pay out \$100 million, having \$50 million in the bank and \$200 million in debt which eventually we have to pay the lenders. So in reality the price we have to pay for the business is equal to \$100 million + \$200 million - \$50 million = \$250 million. And the business is earning \$10 million annually. On this standpoint, the real P/E would be no longer 10, but rather 25, and the real earning yield is 4%.

If we put down \$100 million to purchase company B, we would directly have \$100 million on hand and only have to pay \$10 million in terms of debt. So actually the real price of company B is only \$10 million. And every year, it earns \$10 million. Thus, the real P/E of the company B is now only 1, and the earning yield is at 100%.

So the concept of enterprise value in my opinion is important in picking the right winner, of digging through the financial books to reveal the really cheap companies trading at substantial discounts to their real value. With that in mind, the valuation ratios should be adjusted to reflect the recapitalization level of any certain corporations.

Anh Hoang
Money manager in global equities, especially in U.S. and Vietnam markets. CFA level 3 candidate. Lecturer for Stalla - CFA course in Vietnam.

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Batbeer2 - 5 years ago
Hi Anh,

Thanks for the article.

>> However, if we are the investor and would like to buy out company A, we would have to pay out \$100 million, having \$50 million in the bank and \$200 million in debt

How should one think of the enterprise value if the debt trades at a meaningful discount. It's not uncommon to find \$ 100 bonds available @ \$ 80 or \$ 70.

Hoang Quoc Anh - 5 years ago    Report SPAM
Hi Batbeer,

You raised an interesting point that there is the difference between the market value of the debt and its book value. For the common equity investor, I think to be on the safe side, it should be take the higher value of either book or market value, normally it's the book value.

Because at the end of the day, it is what the company have to pay to the lenders, unless the company use its cash to purchase its debts back at the discounts, then the debt level would decrease, reflecting in the next reporting period balance sheet
Batbeer2 - 5 years ago
Can't argue with conservatism but IMO thinking of enterprise value as the "true" price rules out all well-managed franchises. A company that's able to earn high returns on capital is well-managed if it sells some debt to raise capital.

It's good to look at the level of debt and see if it can be serviced under the worst of conditions. If it can.... fine.

Think of Wells-Fargo. No value investor would have ever bought the company if one had added the debt to the equity to get the "true" price.

Or Loews

Or Berkshire

Or Vodafone

.... basically every stock hschacht likes ;-)
Dr. Paul Price - 5 years ago

You said...

However, if we are the investor and would like to buy out company A, we would have to pay out \$100 million, having \$50 million in the bank and \$200 million in debt which eventually we have to pay the lenders. So in reality the price we have to pay for the business is equal to \$100 million + \$200 million - \$50 million = \$250 million. And the business is earning \$10 million annually. On this standpoint, the real P/E would be no longer 10, but rather 25, and the real earning yield is 4%.

That is wrong, wrong, wrong.

If the market cap is \$100 million (and you could buy all the shares with no premium) and the company is earning \$10 million after tax (which is how EPS are stated) then the P/E is 10x.

The interest costs on the borrowed money were already deducted before the EPS were calculated.

Return on total capital would be different but the 2 companies would each sport P/Es of 10x.
Batbeer2 - 5 years ago
>> The interest costs on the borrowed money were already deducted before the EPS were calculated.

Good point.

However, ignoring the fact that interest expense was untaxed before but will be taxed when it flows down to the bottom line if all debt is retired... could that possibly be wrong ?

>> but the 2 companies would each sport P/Es of 10x.

That makes the one with 0 debt a prime LBO candidate.
Dr. Paul Price - 5 years ago

You don't add or subtract interest expense from stated EPS.

That has already been done to arrive at the after-tax EPS.
Hoang Quoc Anh - 5 years ago    Report SPAM
@Batbeer: Yes, the enterprise value is applied to nearly every sectors but financial companies, for example banking, insurance or mutual funds. Talking about bank, when the leverage is 20 to 1, and there would be a lot of cash in place for banks for the purpose of liquidity.

For other industries, the level of debt is reasonable or not depending on the cash flow it generates and its sustainability of generating those cash flows. The more certain and stable the cash flow, the higher level of leverage that the company can take.

@ Stockdocx: The Price-Earnings ratio if based on the theory would be 10. But it depends on the adjustment you can make with the "Price". When Buffett bought See Candies, he mentioned the price after deducting the cash that See's was having at that time.

You raise the good point of earnings arrived after the interest cost being deducted. That is why if the companies are taking more debt, using the enterprise value would reveal their higher purchase price as well as lower earnings, dragging down the yield further.
Rz123 - 2 years ago    Report SPAM

I can't see how that's correct. If the market cap is 100million regardless of how much debt or cash is on the company's accounts a 10mil yield is still a 10% yield. As such, your outlay as an investor has still only generated a 10% return. Enterprise Value I think is I think somewhat indicative of stability but to say that 100million paid for a company now generates a greater or lesser yield depending on the variable debt/cash balances isn't correct. 10million earnt on a 100million outlay is a 10% yield in both cases regardless of the different cash or debt balances.