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Portfolio123 » List all forums » Forum: Ranking Systems and Factors/Functions » Thread: Enterprise Value (EV) |
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grokkalot
Advanced Member
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I've seen a number of valuation formulas that make use of enterprise value and on P123 they often calculate it using something like: (MktCap-CashPSQ*ShsOutMR + DbtTotQ) To me, it makes more sense to use the formula: (MktCap - CurAstQ + LiabTotQ) This distinction probably doesn't make much difference in most cases, but it is possible to have high liabilities with low "debt" according to the way Reuters interprets those terms and also possible to have a lot current assets that are not cash. So I have come across cases where the second formula made more sense. But I'd like to hear about it if anyone has an argument in favor of the first formula. |
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olikea
Advanced Member
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I believe I came up with the formula you presented, I tried to base it as closely as possible on the "official" definition of enterprise value: http://en.wikipedia.org/wiki/Enterprise_value Enterprise value = common equity at equity value + debt at market value + minority interest at market value, if any - associate company at market value, if any[citation needed] + preferred equity at Book value - cash and cash-equivalents. Unfortunately I couldn't see how to add in all of the above, such as minority interest, using p123, so I put in what I thought were important, namely debt and cash. My understanding of the usefulness of "Enterprise Value" is that it represents the total cost for someone to fully acquire the company, which may actually be quite different to the simple market capitalisation (which is a function of share price alone). In theory, EV/EBITDA is a useful measure of the return on investment of buying the company. You can make an apples to apples comparison by assuming you will pay off all the debt, and then you get the earnings before interest. Similarly, cash is an "instant rebate" so it can be discounted from the price. However, I view other assets and liabilities as being more fuzzy. All companies need some working capital to function, you cannot, for example, take the inventory as a "rebate", because during the normal running of the company, some finite level of inventory is always required. Another way of looking at it is like this: If you imagine taking over the company, you could imagine you get access to all of its book value, which is like a "rebate", but you need to compare this to accounting earnings to get a "return on investment period". Using a ratio like EV/EBITDA cuts through all of the nonsense associated with deprecating assets etc. Instead, effectively you are evaluating the case purely based on the assumption the assets are wortheless (therefore no "rebate"), but equally no asscociated depreciation to consider. But as you pointed out, you only use current assets in the suggestiong for your formula. Though you raise an interesting point - what is the difference between total debt and total liabilities? I actually haven't really thought about this much before, I am not sure how it interacts in my example of a potential takeover situation assessing the return on investment. Anyway, I decided to test three formulas using the ranking buckets, using my liquidity screen ADT > $200k, close(0) > 1, universe(nootc), mktcap > 50 with a 4 week rebalance date using all available data. Shown is the annualised return of each of the 20 buckets (the first few buckets return 0 because of the NA trap): (mktcap + DbtTotQ - (CashPSQ * ShsOutMR)) / Eval(EBITDAq>0,EBITDAq,NA): 0.0 0.0 0.0 0.0 0.0 2.1 -1.5 -0.5 2.1 4.2 7.4 7.6 11.0 11.1 12.3 13.1 15.4 17.6 19.7 25.2 (MktCap + LiabTotQ - CurAstQ)/Eval(EBITDAq>0,EBITDAq,NA): 0.0 0.0 0.0 0.0 0.0 0.0 2.4 -0.1 -0.7 1.9 6.4 6.4 8.8 10.5 10.9 14.0 14.5 16.9 21.6 25.4 (mktcap + LiabTotQ - (CashPSQ * ShsOutMR)) / Eval(EBITDAq>0,EBITDAq,NA): 0.0 0.0 0.0 0.0 0.0 2.1 -1.9 0.4 -0.0 6.6 6.6 7.6 10.6 11.7 10.7 13.3 14.7 18.5 20.5 24.8 As you can see, the formula you suggested is marginally better than the original one I suggested. The third formula I just suggested does marginally worse. However, overall there isn't much difference between all three approaches, I would say its not statistically significant, so it is interesting to focus the discussion on what is "philosophically" the best approach! ---------------------------------------- [Edit 1 times, last edit by olikea at Jul 8, 2008 5:37:16 PM] |
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grokkalot
Advanced Member
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An example might come from a company like TECD that buys computer parts and then sells them to retailers. Reuters would count the money they owe to their suppliers in current liabilities and total liabilities, but not total debt, and of course Reuters doesn't count the receivables owed to them as cash either. http://www.reuters.com/finance/stocks/incomeStatement?stmtType=BAL&perType=INT&symbol=TECD.O Now at the moment, I judge that it's a good thing for TECD not to appear in the highest bin in one of my screens for unrelated reasons, so this quantitative slighting of TECD certainly doesn't hurt, but at some future time when it was a good candidate, the version that measures cash against debt might miss it. On the flip side, shortsellers sometimes look for growing receivables as a sign of a problem, so one might want a different check for that. But clearly we see with TECD that it's liabilities are certainly money it owes that are a lot bigger than both its cash and its "total debt". |
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