Monday, December 8, 2008

Enterprise value is negative... Is that possible?

There are three measures that can be used to capture the market value in a business. We can measure the market value of equity, i.e., the market capitalization of the equity in the firm. We can add the market value of equity to the market value of debt to get the total market value of the entire firm: think of this as the market value of all of the assets of the firm. We can add the market value of equity to the market value of debt and subtract out cash and marketable securities to get to the enterprise value: this, in effect, is the market value of the operating assets of the firm.
We see the first number in equity multiples; the PE ratio and the Price to book equity are computed using the market value of equity. We see the last number in multiples of EBITDA and revenues; the rationale for netting out cash is that the income from cash is not part of either EBITDA or revenues.
All of this leads me to a curious phenomenon that has occurred at some large firms, where the enterprise value has become negative. Here, for instance, is a Bloomberg article on the topic:
http://www.bloomberg.com/apps/news?pid=20601087&sid=ahiVT6vmGNEA&refer=home
In other words, the cash and marketable securities exceed the cumulated market values of debt and equity. In theory, at least, this seems to be an easy arbitrage opportunity, where you can buy all of the debt and equity in a firm and use its cash balance to cover your investment costs and keep the difference. Here are some reasons why you should be cautious:
1. The computed enterprise value may not have captured all of the debt outstanding in the firm. With a retail firm, for instance, enterprise value should include the present value of lease commitments as debt. What you see reported as enterprise values for WalMart, Target and Best Buy is understated because of this failure. In the Bloomberg list, for instance, there are a preponderance of banks and financial service firms. I have always had a tough time defining debt and enterprise value at these firms and am dubious about most of these firms.
2,. The cash that is netted out to get to enterprise value is usually from the most recent financial statement (rather than the current date used for market cap). Given how quickly firms burn through cash, what you see on the balance sheet may not reflect what the firm currently has as a cash balance.
3. Some services are sloppy about their definition of market value and seem to mix up market value of equity with market value of the firm.
The core of the article, though, is that stocks are cheap on a historical basis but history also tells us that there are no slam dunk investment profits. There is a many a slip between the cup and the lip when it comes to arbitrage profits.

17 comments:

shikhil said...

Agree with the false lure created by negative enterprise value. Almost all of the companies in the bloomberg list were Banks. Just because a company has a negative enterprise value doesn't justify investment. Its like asking to invest in Lehman or Bear Sterns right before they went bankrupt.

Hawgdriver said...

Thanks for the article. So I take it that the original article ignores L2 and L3 off balance sheet entries, or just doesn't highlight the difficulty in proper valuation?

Whenever I hear a story like the one in question, my reaction is 'how can you possibly look at these companies in a vacuum'??

cheers

Heshrulz said...

For the lease commitment that you are talking about for Retail companies, isn't it possible to estimate a fair value for the damages that maybe claimed for breaking those lease contracts and then add it to the total debt, so that we get the true EV? I mean isn't that a very normal practice of Equity Analysts?

Aswath Damodaran said...

I am not saying that we cannot compute enterprise value for a retail firm. I just don't think it is done often enough. In fact, some analysts do add an approximation (8 times the lease expense) to debt to get to EV.

Sidhartha said...

I have been looking at a number of companies recently that have negative enterprise value. It becomes more interesting because the sector also has zero debt (minimal operating leases and unconditional purchase obligations). There is some litigation taking place between the companies, but when I quantify it then I still get a zero enterprise value.

To add a little more complication to the mix, these companies are positive cash flow and have a very high component of variable cost in their business models.

Is there something obvious that I am missing?

Acephalous said...

A negative EV means that market is pricing the future growth at nothing/zero i.e which makes sense given that firms don't have visibility even into the next quarter. It could also imply that the liabilities of most of these firms maybe understated as in the case of Bank of New York Mellon (some ongoing Russian lawsuit)

Priya said...

Thanks for the article. another reason for negative EV could be we're assuming a very low of operating cash and overestimating excess cash that we can net out to calculate the EV. most analysts seem to just use total cash. Also we see this phenomenon more in high tech historically than any other sector. Damodran.. any thoughts on how to interpret negative EV when stock markets are relatively stable?

dharma said...

i guess ultimately where there exists sizeable cash (adjusted for debt)on the books of the company, the market cap will equate itself to the adjusted cash per share in the long run given decent fundamentals.

anupam said...

Prof- thanks for the article. this is very apt, given the current times. Lot of people are using such analysis to do bottom fishing in the market.

In fact, I have been using experimenting in market using following criteria

a)firms with ZERO long term debt on B/s - protects them from credit crisis. mostly consumer goods and tech companies will fall in this bracket-- they are "lesser" impacted by crisis.

b) then narrow down to firms with price to book value <1.

c) then look for firms with Cash/Share closer to Price/Share.. In some cases, there are Cash/Share higher then Price/Share, as u have pointed out.

d) and then look at at other aspects like mgt, prospects, goodwill present in B/s, institutional share holding etc of shortlisted firms meeting above 3 criteria.

do u think it makes sense... i dont expect you to comment on my investment methodology but theoretically does it makes sense.?

Sunil said...
This comment has been removed by the author.
Sunil said...

Hi

Thanks for this article on negative EV. I was also facing this kind of issue for certain companies which we were considering as peer companies for one of the unlisted company which we are valuing. Now the question is what do we do in this kind of scenario, even after proper consideration of lease and other debt based securities, EV is negative because market cap is too low which is possible due to poor market condition and stocks are down like anything. Please suggest.

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Paul said...

i'm running into the exact situation as sunil - using comps to value a private entity, but all the EVs are negative. any thoughts?

Sudhir Varma Kammili said...

Sir, could you please explain how do we calculate using the comparable companies analysis, the multiples of an unlisted company.Your answer would help me a lot for my internship in an investment bank.

Sudhir Varma Kammili said...

Sir, could you please explain how do we calculate using the comparable companies analysis, the multiples of an unlisted company.Your answer would help me a lot for my internship in an investment bank.

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