A Value Investing Toolkit (1): Enterprise Value
Leading up to the International Value Investing Conference on October 23 and 24, Jos van Bommel, associate professor of Finance at the University of Luxembourg, will regularly share his insights on some basic tools and concepts relating to value investing.
1. Enterprise Value
In this blog I will discuss some basic tools and concepts for the modern value investor. Particularly, I will discuss Valuation Multiples, Going Concern Value, Return on Invested Capital, Corporate Governance, and other tools and concepts. The first topic will be Enterprise Value, a metric that has become increasingly popular over the last few decades.
Most investors and analysts define Enterprise Value (EV) as the sum of the Net Debt and the Market Capitalization of a firm. In my Corporate Finance classes I typically explain EV with a picture of what I call the “Market Balance Sheet”: Two columns of which the left one is called “Enterprise Value”, and the right one is split into “Net Debt” on top, and a larger “Market Capitalization” on the bottom. The market balance sheet shows how EV is shared between debt-holders and equity-holders. I then explain that a firm’s Net Debt is its interest bearing debt less its cash, and that the relative sizes of Net Debt and Market Cap in the picture are typical, but can change dramatically from firm to firm. Indeed, some firms have negative Net Debt - sometimes called “excess cash” - and therefore have Market Caps that are higher than their EV.
The EV is a market value. In an efficient market the EV should equate the present value of the free cashflows generated by the enterprise or the business. Of course value investors do not believe in the efficient markets but believe that EV is determined by “Mr. Market”, a moody and emotional character who often gets it wrong. Value investors think of EV as the price for which they can buy the business. They naturally look for businesses trading at low EVs. More precisely, value investors buy businesses that are trading below their intrinsic value, preferably by a big margin of safety.
Benjamin Graham, often considered the Godfather of Value investing, would have compared the EV with the book value of the firm’s assets less its non-interest bearing liabilities, which we nowadays call the Invested Capital (a.k.a. the Capital Employed). In today’s jargon, Graham and other early value investors looked for corporations whose EVs were trading significantly below their Invested Capital. Nowadays such situations are difficult to find, and if we find them, they may still not represent good investment opportunities. An example is a beer brewer that owns a huge production facility that is standing idle due to lack of the demand for its beer. Today’s value investors will therefore not only look at the book values but also at the going concern values, to which I will come back in a later blog-entry.
Value investors should be careful not to underestimate EV. If they do, they may incorrectly conclude that the company’s stock is cheap. There are several ways in which you can underestimate EV. A fundamental flaw of EV is that cash is valued at its face value. In reality, a € in the firm is worth less than a € in the investors pocket!! An obvious reason is taxes on dividends and other distributions. Another reason is that not all cash is excess cash! Part of it (and for some firms all of it) is operating cash, that is tied up in the business forever, and should not be added to the EV (or subtracted from the Debt) to estimate the intrinsic value of a share. Serious value investors assess how much of the cash is ‘operating cash’ and deduct it from the total cash-figure, and then discount the remaining balance to account for taxes and other spillage.
Another danger is that a myopic EV underestimates the value of the debt. Many data providers just take the book value as a proxy for market value of the debt. For the kind of stocks that value investors often look at (medium-sized sound and stable firms), the true economic value of debt may be much higher than the book value, due to recent rating increases or interest rate decreases. A particular danger is convertible debt, or debt with other off-balance sheet “equity kickers” that present valuable claims on the business and should be added to the EV. Particularly dangerous are “hanging convertibles”, that are ‘in the money’ and of which the value can be very substantial, particularly for small and medium sized firms. Be particularly cautions for firms that spent time in private portfolios. Private Equity investors often use convertible financing to retain control in bad times and share in the upside when things go well. Beware also of the option value, due to which convertible debt is in fact more valuable than the maximum of the face value and the conversion value.
Families, managers, or other special shareholders may also have valuable off balance sheet rights and options that need to be considered when computing the EV determined by Mr. Market, and comparing it with the Intrinsic Value of the Invested Capital. An esteemed Value Investor recently explained me a case where minority shareholders had valuable off-balance sheet put-options giving them the right sell their shares at a fixed price. And then there are the notorious pension deficits. If a firm’s balance sheet shows an ‘unfunded pension liability’, value investors would be wise to not simply add it to the EV, but look deeper to see whether the reported value covers the deficit’s true economic value. It is well-known that large US firms (as well as states and municipalities) often use very questionable (i.e. too high) discount rates to estimate the value of their pension liabilities, leading to severe underestimation of the deficits, and making EVs look lower than they really are.
In short, although EV is at first sight an elegant and simple value metric, cautious value investors will be wary of just taking the metric from Bloomberg, and instead make adjustments to take account of the true value of the cash, which is often lower than the reported number, and the true value of the debt and the equity claims, that may be higher due to convertibility and other hidden options.