Problems with Enterprise Value and better valuation techniques

Question

Enterprise Value is often cited as a better measure of valuation than Market Capitalization. The formula for Enterprise Value starts with Market Capitalization and then adds debt and subtracts cash (as well as other inputs). The high-level idea is that if you were to sell a company you would have to consider more than just what the market determines the shares are worth. But I see a circular logic problem here. The Market Cap is driven by the share price and the share price is determined by buyers and sellers who have access to data on cash and debts and factor that into their decision to buy or sell.

1. Am I missing some key concept that allows us to separate cash/debt from market cap or is this a known problem with EV?
2. What are some of the best alternatives to EV for valuation?

Answer 1

This is a tough question SFun28. Let's try and debug the metric.

First, let's expand upon the notion share price is determined in an efficient market where prospective buyers and sellers have access to info on an enterprises' cash balance and they may weigh that into their decision making. Therefore, a desirable/undesirable cash balance may raise or lower the share price, to what extent, we do not know.

We must ask How significant is cash/debt balance in determining the market price of a stock?

• As you noted, we have limited info, which may decrease the weight of these account balances in our decision process.

• Using a materiality level of 5% of net income of operations, cash/debt may be immaterial or not considered by an investor.

• investors oftentimes interpret the same information differently (e.g. Microsoft's large cash balance may show they no longer have innovative ideas worth investing in, or they are well positioned to acquire innovative companies, or weather a contraction in the sector)

My guess is a math mind would ignore the affect of account balances on the equity portion of the enterprise value calculation because it may not be a factor, or because the affect is subjective.

Answer 2

How you use the metric is super important. Because it subtracts cash, it does not represent 'value'. It represents the ongoing financing that will be necessary if both the equity plus debt is bought by one person, who then pays himself a dividend with that free cash.

So if you are Private Equity, this measures your net investment at t=0.5, not the price you pay at t=0. If you are a retail investor, who a) won't be buying the debt, b) won't have any control over things like tax jurisdictions, c) won't be receiving any cash dividend, etc etc .... the metric is pointless.

Answer 3

From Wikipedia:

Usage

• Because EV is a capital structure-neutral metric, it is useful when comparing companies with diverse capital structures. Price/earnings ratios, for example, will be significantly more volatile in companies that are highly leveraged.

• Stock market investors use EV/EBITDA to compare returns between equivalent companies on a risk-adjusted basis. They can then superimpose their own choice of debt levels. In practice, equity investors may have difficulty accurately assessing EV if they do not have access to the market quotations of the company debt. It is not sufficient to substitute the book value of the debt because a) the market interest rates may have changed, and b) the market's perception of the risk of the loan may have changed since the debt was issued. Remember, the point of EV is to neutralize the different risks, and costs of different capital structures.

• Buyers of controlling interests in a business use EV to compare returns between businesses, as above. They also use the EV valuation (or a debt free cash free valuation) to determine how much to pay for the whole entity (not just the equity). They may want to change the capital structure once in control.

Technical considerations Data availability

Unlike market capitalization, where both the market price and the outstanding number of shares in issue are readily available and easy to find, it is virtually impossible to calculate an EV without making a number of adjustments to published data, including often subjective estimations of value:

• The vast majority of corporate debt is not publicly traded. Most corporate debt is in the form of bank financing, finance leases and other forms of debt for which there is no market price. * Associates and minority interests are stated at historical book values in the accounts, which may be very different from their market values. * Unfunded pension liabilities rely on a variety of actuarial assumptions and represent an estimate of the outstanding liability, not a true “market” value. * Public data for certain key inputs of EV, such as cash balances, debt levels and provisions are only published infrequently (often only once a year in the annual report & accounts of the company). * Published accounts are only disclosed weeks or months after the year-end date, meaning that the information disclosed is already out of date.

In practice, EV calculations rely on reasonable estimates of the market value of these components. For example, in many professional valuations:

• Unfunded pension liabilities are valued at face value as set out in notes to the latest available accounts. * Debt that is not publicly traded is usually taken at face value, unless the company is highly geared (in which case a more sophisticated analysis is required). * Associates & minority interests are usually valued either at book value or as a multiple of their earnings.

Avoiding temporal mismatches

When using valuation multiples such as EV/EBITDA and EV/EBIT, the numerator should correspond to the denominator. The EV should, therefore, correspond to the market value of the assets that were used to generate the profits in question, excluding assets acquired (and including assets disposed) during a different financial reporting period. This requires restating EV for any mergers and acquisitions (whether paid in cash or equity), significant capital investments or significant changes in working capital occurring after or during the reporting period being examined. Ideally, multiples should be calculated using the market value of the weighted average capital employed of the company during the comparable financial period.

When calculating multiples over different time periods (e.g. historic multiples vs forward multiples), EV should be adjusted to reflect the weighted average invested capital of the company in each period.

In your question, you stated:

The Market Cap is driven by the share price and the share price is determined by buyers and sellers who have access to data on cash and debts and factor that into their decision to buy or sell.

Note the first point under "Technical Considerations" there and you will see that the "access to data on cash and debts" isn't quite accurate here so that is worth noting. As for alternatives, there are many other price ratios one could use such as price/earnings, price/book value, price/sales and others depending on how one wants to model the company. The better question is what kind of investing strategy is one wanting to use where there are probably hundreds of strategies at least.

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Let's take Apple as an example. Back on April 23, 2014 they announced earnings through March 29, 2014 which is nearly a month old when it was announced. Now a month later, one would have to estimate what changes would be made to things there. Thus, getting accurate real-time values isn't realistic. Discounted Cash Flow is another approach one can take of valuing a company in terms of its future earnings computed back to a present day lump sum.

Answer 4

This is an example from another field, real estate.

Suppose you buy a $100,000 house with a 20 percent down payment, or $20,000, and borrow the other $80,000.

In this example, your "equity" or "market cap" is $20,000. But the total value, or "enterprise value" of the house, is actually $100,000, counting the $80,000 mortgage.

"Enterprise value" is what a buyer would have to pay to own the company or the house "free and clear," counting the debt.