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:
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.