Saturday, October 1, 2011

Lesson 12: Enterprise Value vs Price Earning ratio

EV (Enterprise Value) is a metric to describe your potential cost/risk when purchasing a WHOLE company. PE (Price to earnings ratio) is the amount that you're willing to pay per dollar worth of earnings.

When you take ownership of more than 50% of a corporation, you need to consolidate the assets and liabilities into your own financials. You will now be responsible for the debt.

Most, probably all of you reading this have no plans to acquire more than 50% of any corporation. When you purchase stock, your liabilities are limited to the price that you pay. If you buy a stock at $50, that's all you can lose. If you buy the whole company (or any amount more than 50%) for $50m which has $10m in debt, you are now responsible for the repayment of the debt.

This is the reason that Buffet purposely stays just under 50% ownership for some of his positions. He wants only the upside potential of the equity without being liable for the debt used.

I like PE because it has an inherent component which is attached to the return on equity and return on assets, which are the most important metrics. Let's say there are two companies which are identical in almost every single way. Each company makes 3 dollars per year. I've established in a prior post that if we were to pay 10 dollars to buy such a company, we'd get a 30% return on investment. My example was super simple, and assumes that the company has no excess cash.

Now, to introduce the new complexity. Company A has $100 excess cash its bank account and generates $3 per year. Company B has $1000 excess cash its bank and generates $3 per year. Assume no debt at this point. The price you pay for each company must at least be a sum of its parts. Assuming you can buy the income generation portion for $10, you would need to purchase company A for $100 + $10 =$110, yielding a PE of 110/3 = 37. Company must be purchased for $1000 + $10 = $1010, yielding a PE of 1010/3 = 337.

PE ratio is penalizing Company B for an inefficient use of assets. However, EV/EBITDA would rate them both the same. (In this case, it's EV = Market Value - Excess Cash) If you were to buy less than 50% of company B, so that you could not pull out the excess cash, you end up getting a much lower return on investment. (Using $1010 to earn $3 per year vs $110 to earn $3 per year).

Some people may have been misled while learning about EV. You've probably learned or have been told that a company which issues stock to retire debt will cause the PE to go up.  As a result, some people prefer EV over PE because it does not depend on capital structure. There will be more outstanding shares, causing earnings per share to go down, which causes PE to go up. This is only sometimes true.

What you're not accounting for is that earnings will change after the retirement of debt, due to a decreased amount of earnings going to pay interest. Consider a company with a net income of 0, due to 100% of earnings going to paying interest. This company has a lot to gain from issuing stock to retire debt. You can expect the PE ratio to go DOWN in this case, completely opposite of the generalization.

A company that has no debt and earns 50% return on assets may have a lot to gain by issuing debt and paying a 4% interest, assuming it can deploy the new money near 50% ROA. In this case, you can expect the PE ratio to increase, but you can also expect to see an increase in net income.

It's actually good that PE discriminates between capital structures. In my previous example, with a company of 0 net earnings due to paying 100% to interests, there's a clear advantage in changing the capital structure by issuing stock to pay off debt. It's very handy for the PE to drop as a reflection of the change in capital structure from an inferior state to a more advantageous state. I actually think it's bad that EV/EBITDA can't discriminate between this difference, because I won't be able to acquire more than 50% of a corporation any time soon. By removing cash and debt from the calculations, you end up with a different return on assets calculation, which is an inaccurate portrayal of the company.

If you were able to buy more than 50% of either company, you can pull the excess cash for yourself and the purchase of either company would truly be identical. It is inappropriate for me to use EV/EBITDA because I'm buying less than 50% of a company. PE is far more appropriate for me. Do not completely discard EV/EBITDA. It is useful and can be used in conjunction with PE. Understanding the math and the implications of the numbers allow you to pick an appropriate metric for the right situation.

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