It's a bit hard for me to wrap my head about this "borrowings" as being part of the positive part of the equation. I understand that if you want to buy the company, then you need to pay that off, but is that really "value" in the way the article says to compare companies?
- Imagine a company with 0 market cap and 0 cash, but 100M in debt. That company would be "enterprise valued" at 100M.
- How can you compare that to a different company, let's say at 100M market value, with 0 debt and 0 cash and say they are the same for "enterprise value"?
- Or to go even funnier, an arbitrary high market value, let's say X + 100M, with an arbitrary large amount of cash, let's say X, and say that both of those companies have the same "enterprise value" as one company that has 0 market cap and 0 cash but 100M in debt?
When trying to get a "peasant estimation" of how big a company is (not in a "how much it'd cost for me to buy it" way), which is what the article is trying to argue, I'd say that it should be "market cap + cash - borrowings". Or maybe not even include the cash and borrowings, or do some more advanced calculations I don't know about, since the market probably accounts for those indirectly on the market cap!
For your company A, you need to pay 0 to buy all its share, and also pay 100M to the lender to have full-control of the company.
For your company B, you need to pay 100M to buy all its share, and also pay 0 for the debt.
So they are both going to cost 100M for you as potential buyer.
To expand a little bit, actually the "cost to buy" should exactly be how "valuable" it is. But why does it feel counterintuitive? Because when we're thinking about buying something, we usually don't really logically.
Say you want to buy a car at $10000. But it also has a broken AC and you have to fix, which costs you $1000. At the end of the day, to buy a "car with a working AC" you paid $11000. That's the value of the car.
But most people will think they "spent $10000 to buy car that actually only worth $9000". Is that true? For a totally fair market, you CANNOT buy the same car with working AC for $10000. It would be priced as $11000. Same goes for the company -- a company the has exactly "same" inherent value", whatever that means, but no debt, would have higher market value than the one with. So the market value, at least in theory, already reflected that difference. Hence you can add it together with the debt to get its "true value".
I had to re-read this few times but I think it makes sense now. So what you are saying is, that if a company goes into debt, the market will also lower its valuation because it has debt, so we should not count this debt twice and that's why we need to add it up?
I think we might be missing "assets" here? This is what still doesn't make sense for me:
- A company just created (market cap 0) goes 100M into debt, and so has 100M cash, so it balances out to be 0.
- However if that company uses those 100M cash to buy e.g. a factory, in this example what would happen? The Market Cap jumping to 100M doesn't make sense (since then the company would be "valued" at 200M), should we count the "assets" in the same way as "cash"?
>- Imagine a company with 0 market cap and 0 cash, but 100M in debt. That company would be "enterprise valued" at 100M.
The fallacy here is assuming that market cap is an independent variable, whereas in real life it's dependent on cash/debt. This makes sense, because a company loaded with debt would be less valuable to shareholders, since the debt has to be serviced which eats into future profits. If you set all 3 values arbitrarily, of course you're going to get absurd results. It's not any different than setting the side lengths of a right angle triangle to arbitrary values, then complaining that the Pythagorean theorem is broken.
In other words market cap is assumed to be representative of the company's "actual value" (i.e. whether it is a good investment, profitable, whatever) and the other variables are meant to correct for factors the market cap presumably does not consider.
But that is still counter-intuitive if we use an intuitive understanding of "value" (i.e. worth preserving/having/acquiring). The company in this example would have no worth but EV of 100M. If you buy it, you would have gained nothing and spent 100M. Realistically with (near) zero market cap the company is likely defunct or worthless, with zero cash and massive debt it's likely bankrupt.
Realistically it's just a base "buying price". To fully buy out and own a company you would need to buy all the stock (market cap) and then pay off all the debt but you could use the cash for that. That's "value" in the modern economical "market price" sense, not in any intuitive sense. And it doesn't even mean paying that price would be a good investment because two different companies may have the same price but be hugely different in terms of potential ROI. Notably it only accounts for assets in the sense that the market cap might consider them - but we all know (do we?) that the stock market is not rational even when it can be rationalized otherwise we would be better at predicting it (notably a lot of "experts" perform worse than chance when trying to predict it).
I guess if you wanted to account for value in the sense of "worth" the formula would have to be a multiplier of the share price as a share price of zero would presumably mean the market sees no use in it and the other factors don't matter (but then again there's no good reason why debt would factor into it positively because it's merely a proxy for capital based on the assumption that it's used for investments rather than cashflow).
I did touch on this: "Or maybe not even include the cash and borrowings, or do some more advanced calculations I don't know about, since the market probably accounts for those indirectly on the market cap".
If they are not independent variables, then it's also not fair to plainly add variables that depend on each other, since they will give a skewed value given that simple addition would assume they are independent.
The submission doesn't state it explicitly, but a firm's debt enters its Enterprise Value at its market value, not its nominal value [0]. If an openly traded company (a company that has non-zero shares) had a market capitalization of zero dollars, the market value of a bond issued by it would be, most likely, also zero, or very close to zero, even if its face value were non-zero.
If the market values a firm's stock at zero dollars because it isn't expected to increase in value nor to pay any dividends at any time in the future, then it wouldn't be expected to pay back any of its debt either, and so the market value of its debt would also be zero.
As I understand it, the majority of debt of car companies is used to provide leases.
So e.g. GM borrows money at X% interest rate and gives credit to customers at X+Y%.
Y% is their profit. So the bigger the debt, the more additional profit they make.
This is also a ticking bomb because leverage generates more profit when times are good but increase losses when times are bad.
That Y% finances the risk that a customer will stop paying.
It also comes from GM being able to re-sell the car after the lease for more that it's worth ($PriceOfCar - $TotalLeasePayments).
When bad times come, like in 2008, those companies are hit with double whammy: people have less money, so more people abandon the lease. And also buy less cars so car prices drop so re-sell value drops.
So suddenly GM has losses and cannot afford the debt payments and that's how they go bankrupt.
If you acquire the company, you assume it's debt, too. So that's a liability you assume, meaning you have to pay that on top of paying for the market cap of the company. You also get the cash, which is a reward for buying the company. So to buy the company and pay off all the debts.
Example:
- Company Stock is worth market cap of 2 billion.
- Company has 2 billion in debt.
- Company has 1 billion in cash.
2B (acquiring all the stock) + 2B (paying off all the debt) - 1B (cash in the bank) = 3B (enterprise value, aka the effective price to buy the company w/ no debt).
Some people call the enterprise value the true price of the company.
I think the confusion lies in the word "value". To use your example of Company, imagine another company (Company2) exactly the same as Company but without the debt. Enterprise value of Company is 3B, enterprise value of Company2 is 1B. But Company2 would clearly be preferential to acquire, because it has no debt, despite the much lower enterprise value. So enterprise "value" is not a useful measure of "value". Am I misunderstanding something here?
The part you're missing is that the 3 variables aren't independent of each other or of the underlying company. You'll never have two 'identical' companies that only differ in one of those variables.
If company 2 has the same market cap with zero debt as company 1 has with huge amount of debt, then that implicitly means that the market values what company 2 does less. Perhaps they're in a market with lower growth or have a smaller market share or have a product with less upside potential or have huge lawsuit hanging over them.
If company 1 and company 2 did the same thing and had the same profits and sales, but the only difference is that company 1 had a lot more debt, then the market cap of company 2 would almost certainly be higher than the market cap of company 1. In fact you could then use the Enterprise Value formula to work out what the market cap of company 2 'should' be.
Ok I understand what you're saying, but this is still treating debt as a negative despite the fact it has a positive influence on the enterprise value.
Imagine this example. I'm CEO of Company2 and I take out a 1B loan. Enterprise value is still 2B, because 1B debt is cancelled by the 1B I now have in cash. I then waste all the cash on whatever. My company's enterprise value is now 3B, because the debt has increased it without being cancelled by the cash.
Depends on what you did with your cash. If you wasted it on something (perceived as) 'stupid' then your stock price would go down, lowering your market cap and your enterprise value would stay the same. If however you invested that cash into something perceived as 'smart' then your company will now be better off in some dimension, and thus it makes sense that your company will be worth more.
Equally if you are able to take on a lot of debt without it lowering your stock price then that means that the market thinks you're going to use that new money in a smart way to grow your companies value and thus your company is more valuable. If the market didn't believe you would use the debt wisely, taking on debt will lower your stock price.
In the real world you effectively cannot change the amount of cash or debt you have without it affecting your market cap in some way, as all three are tied together in complex ways and this model doesn't offer any insight into how changing one value will affect the others or the overall value going forwards. Think of Enterprise Value just as the price tag of a company at any given moment in time.
Gotcha. To go back to the article, it compares Tesla vs Toyota's market cap (558 vs 329) and then their enterprise value (553 vs 466) and concludes that if we look at EV then Toyota has almost caught up. What this reveals is that the market has decided that Toyota is in a good position ("valuable") because they have a market cap reasonably close to Tesla despite a lot more debt, so there is inherently some extra value in Toyota (according to the market) not captured by just looking at the diff between Tesla and Toyota market cap. It also reveals that Toyota believes they're undervalued which is why they're using debt financing instead of shares, whereas Tesla thinks the opposite.
Consider the opposite. The company has a market cap of $100bn and $10bn in cash. If you buy the company out for $100bn, you automatically also get $10bn cashback. So it's more like it is worth 90bn, plus has some cash attached - but that bit is a wash.
Debt is negative cash, so instead of subtracting it from market cap, you add it in.
"enterprise value = market cap + borrowings - cash"
It's neat and not too long.