Motley Being a Fool on "Enterprise Value"?
A colleague asked me about “enterprise value” and passed along this discussion:
Enterprise value (EV) represents a company’s economic value — the minimum amount someone would have to pay to buy it outright. It’s an important number to consider when you’re valuing a stock.
You may remember that market capitalization (the current stock price multiplied by the number of shares outstanding) also serves as a company’s price tag. But market cap ignores debt, and with some companies, debt is substantial enough to change the picture significantly. Enterprise value, on the other hand, is a modification of market cap that incorporates debt.
To better understand the concept of enterprise value, imagine that you’re looking at two companies with equal market caps. One has no debt on its balance sheet, while the other one is rather debt-heavy. If you owned the latter company, you’d be stuck making lots of interest payments over the years, so you probably wouldn’t pay the same price for each company.
At the risk of saying something foolish that I will later have to retract…the above strikes me as ridiculous. It’s like asking if a pound of feathers is lighter than a pound of lead. Investors presumably understand how debt works, and so if they are valuing a debt-heavy company at $50 billion and a debt-free company at $50 billion, the first company must be superior in other respects.
Just look again at the last sentence in the quote above: The writer is saying “You would pay more for the first $50 billion company than for the second $50 billion company.” Huh?
If you still don’t see it, try this one:
Suppose you have one million-dollar-property in a low-tax region, and a different million-dollar-property in a high-tax region. Because you would have to make lower tax payments, you would be willing to pay more for the first property than for the second.
Let me kick this thing one more time, just to make sure you realize how crazy it is. Let’s go with the guy in his example. Because of the huge popularity of Free Advice, millions of people read the Motley Fool analysis, slap their foreheads, and say, “Holy cow! It never occurred to me to look at a company’s debt before buying its stock. Let me go investigate this new angle.”
The two companies originally had a market cap of $50 billion a piece. Now, because of the Motley Fool revelation, investors pay more for the shares of the debt-free corporation and less for the shares of the debt-heavy company. The debt-free market cap rises to $51 billion, while the debt-heavy market cap sinks to $49 billion.
The same process happens with every corporation on the exchange. Investors suddenly take debt into account when bidding on stocks.
Now, after the dust settles, we once again look for two companies of equal market cap, but with vastly different debt loads.
Can we once again use the Motley Fool article to prove that these companies are obviously mispriced?
