Why enterprise value? kcchongnz

kcchongnz

Publish date: Thu, 27 Mar 2014, 07:29 AM

“What is a cynic? A man who knows the price of everything and the value of nothing” Oscar Wilde

Two companies, A and B in exactly the same industry have the same number of shares with the same share price, and hence the same market capitalization of 100m as shown in Table 1 below.

Table 1

Company	A	B
No. of shares, m	100	100
Share price	1.00	1.00
Market Cap, m	100	100
Total debt, m	50	10
Excess cash	10	20

A has a total debt of 50 million and an excess cash of 10m, whereas B has a total debt of 10m but an excess cash of 20m. Table 2 below shows the income statements of the two companies:

Table 2

Company	A	B
EBIT	15.8	13.8
Interest	-2.5	-0.5
EBT	13.3	13.3
Tax @ 25%	-3.3	-3.3
Net income	10.0	10.0

Both companies make a net income of 10m. Hence both A and B is selling at a price-earnings ratio of 10 (100m/10m). But are they having the same value? If not, which company would you prefer to invest in?

One way to look at it is considering the total enterprise value (TEV) of A and B and see which one is cheaper to buy the whole business as explained in Investopedia as below:

[Think of enterprise value as the theoretical takeover price. In the event of a buyout, an acquirer would have to take on the company's debt, but would pocket its cash. EV differs significantly from simple market capitalization in several ways, and many consider it to be a more accurate representation of a firm's value. The value of a firm's debt, for example, would need to be paid by the buyer when taking over a company, thus EV provides a much more accurate takeover valuation because it includes debt in its value calculation.]

TEV = Market Capitalization +Debt +Preferred Share Capital + Minority Interest - Cash

TEV of A is 140m (100+50-10) and B is 90m (100+10-20). B is clearly a cheaper and a better value buy. Debt and cash can have an enormous impact on a particular company's enterprise value. Hence when evaluating the fair price of a company or comparing companies, A better measure of value is the enterprise value over the earnings before interest and tax (EBIT), instead of the too simplistic or flawed PE ratio.

For Table 2 above, both A and B produce the same net income of 10m, but A has a higher EBIT of 15.8m and B a lower EBIT of 13.8m. However, the TEV/EBIT for A is 8.9 times (140/15.8), 36% higher than the 6.5 times (90/13.8) of B. Hence B is clearly a much better buy than A.

In term of return of capital, the ROC (EBIT/TEV) of B is 15.3% (13.8/90), which is much better than that of A of 11.3% (15.8/140), Although both has the same ROE of 10%.

For those who are interested in the comparison of enterprise values of some construction companies can refer to the following link:

http://klse.i3investor.com/blogs/kcchongnz/46573.jsp

Why Is Enterprise Value Important?

Some investors, particularly those that follow a value philosophy, will look for companies that are generating a lot of cash flow in relation to enterprise value. Businesses that tend to fall into this category are more likely to require little additional reinvestment; instead, the owners can take the profit out of the business and spend it or put it into other investments.

KC Chong in Auckland (27/3/14)

Discussions

5 people like this. Showing 19 of 19 comments

stockoperator

Very Educational.

2014-03-28 11:52

Horsefield

Hi KC,
I did some simple calculation on FACBIND below. It appears to be negative enterprise value stock now (closing price of RM1.26 dated 28-March). Do you considered it as an arbitrage opportunity? And do you see any pitfall or risk in investing in FACBIND despite its cash rich position, disposal of losing money division & low margin bedding business? TQ

Financial Result Ended 31 December 2013:
Enterprise Value
Closing Price at 18/3/2014 1.26
No. of Share 83,882,800
Market Capital (RM' 000) 105,692
Minority Interest (RM' 000) 16,606
Total Debt (RM' 000) 0
Associates (China) (RM' 000) 22,285
Excess Cash 147,908
TEV (RM' 000) -47,895

Deposits, cash and bank balances (RM' 000) 147,908
Current Asset (RM' 000) 181,126
Current Liabilities (RM' 000) 12,972
Excess Cash (RM' 000) 147,908
Excess Cash = Total Cash - MAX(0,Current Liabilities-Current Assets)

Graham Net Net
Deposits, cash and bank balances (RM' 000) 147,908 100% 147,908
Investments (RM' 000) 27,175 100% 27,175
Associates (China) (RM' 000) 22,285 100% 22,285
Receivables (RM' 000) 17,238 75% 12,929
Inventories (RM' 000) 15,980 50% 7,990
PPE (RM' 000) 6,046 30% 1,814
Deferred tax assets (RM' 000) 1,000 0% 0
Total assets (RM' 000) 237,632 ------- 220,100
Total liabilities (RM' 000) 13,164 100% 13,164
Net assets (RM' 000) 224,468 ------ 206,936

No. of Share 83,882,800 83,882,800
NAB (RM) 2.68 2.47

2014-03-28 22:11

kcchongnz

Horsefield, you are very good in your valuation.

Arbitrage opportunity is the opportunity to buy an asset at a low price then immediately selling it on a different market for a higher price. If you can buy FACB at RM1.26, turn around and sell it for RM2.47, your net net value computed for FACB, you make RM1.21 per share, that is arbitrage. The RM1,21 you gain represents an arbitrage profit, or a risk free arbitrage profit. But can you? Where got big fat frog jumping around for you to catch?

But you may try to engage in a risk arbitrage due to the apparent price difference of the market and the real value of FACB. Do the following:

Borrow, million RM 107
Buy all shares at RM1.26 107
Clean the cash drawer 149
Pay bank -107
Pocket cash, m 42

Yes, you borrow 107m from the bank, buy up all shares of FACB at RM1.26 per share, take the cash and use part of it to pay back your loan. At the end you pocket 42m, and still own the whole company, debt free, and with a RM21m worth associates, some inventories and net receivables.

But can you do it? Can you get the money from the bank? Can you get all the shareholders to sell you? And many other questions. This is a risky arbitrage. If the shares are not tightly held, there may be a chance of a hostile takeover someday. It is still a risky arbitrage, not the normal risk free arbitrage per se.

But in my opinion, investing in FACB at RM1.26 has very little risk, if any. FACB is highly undervalued. It has a negative enterprise value as calculated by you, and I agree. Its cash alone of RM1.75 is higher than its market price. But what is the catch? You have no control if the cash eventually belong to you. Management may use the cash to do some stupid things etc.

However, looking at FACB, it is really worth a stock to invest in your Graham net net, or negative enterprise value portfolio. Very limited downside, and plenty of upside. It has positive ebitda, or even ebit. For the last two years, on average, there was positive cash flows from operations too. Hence it is not a cash burner.

If you know the management and trust the management, close one eye (or even both eyes) and invest in it.

2014-03-29 13:05

Horsefield

Limited downside with potential upside (potential catalysts from steel business recovery, special dividend or acquire new business) making this stock attractive to me.

Very appreciate for your valuable explanation & guidance. I learned all the financial statements & valuations from your articles & recommended books. It leads me to the right way (at least for me) of stock investing. Thanks again.

2014-03-29 16:21

kcchongnz

Horsefield,

Thanks for your kind words.

A teacher's greatest reward is that his student excel in his future undertakings.

See what you have written just two months ago in one of my blogs:

Posted by Horsefield > Jan 26, 2014 02:20 PM | Report Abuse

i think its good time to "realize" the loss and ride the young energetic horse (ie ptaras, kfiama, presbhd etc) now..

Just two months past, your return in all the three stocks are all double digits, even in the twenties percent.

Stock 26/01/2014 28/03/2014 Gain
Pintaras 2.68 3.08 15%
Kfima 1.93 2.34 21%
Prestariang 3.10 3.78 22%

The blog you have commented is actually about avoiding the pitfalls in investing. And by taking care of your downside, the upside has taken care of itself, immensely.

2014-03-29 16:47

sense maker

I thought FACB has sold off its loss-making steel biz and some land long ago and has been sitting on a big pile of cash, while hanging on to the sluggish dunloppillow biz, without a clear direction in which it wants its biz to go.

2014-03-29 18:20

Horsefield

sense maker,

For steel biz, its Financial Result ended 30-Sept-2013 quoted "The stainless steel fitting recorded marginal profit as business operations stabilized since commencement of operation in the previous quarter." You can also refer to its subsidy web as below:
http://www.ktfittings.com/Company-Profile/

I believe you are referring to FACB bedding brand named Dreamland instead of dunloppillow which is its competitors.

Financial Year - 2014 Q2 - 2014 Q1 - 2013 - 2012
Bedding
PAT (RM' 000) - 1,360 - 406 - 3,377 - 3,150
EPS (cent) - 1.62 - 0.48 - 4.03 - 3.76
Associate
PAT (RM' 000) - 1,376 - 801
EPS (cent) - 1.64 - 0.95
Interest income
PAT (RM' 000) - 1,128 - 1,426
EPS (cent) - 1.34 - 1.70
Steel
PAT (RM' 000) - -738 - 5
EPS (cent) - -0.88 - 0.01

Total 2Q EPS (cent) - 6.87
Annualized EPS (cent) - 13.74
Trailing PE - 9.17

At reasonable trailing P/E of 9.2, either better performance from steel segment with little growth from bedding segment, possible special dividend or better use of the cash will unlock the value of the stock. In my opinion, it is a defensive stock which is safe to invest at the current market.

2014-03-30 13:17

ping

Why some people use EV/EBIT and some use EV/EBITDA?

2014-03-30 22:30

kcchongnz

Posted by ping > Mar 30, 2014 10:30 PM | Report Abuse

Why some people use EV/EBIT and some use EV/EBITDA?

The difference between ebit and ebitda is the previous takes into consideration of a relevant part of the cost of doing business, ie, depreciation and amortization; whereas the later doesn't. The latter is like earnings before all the bad stuff.

I guess you can use either as long as you are comparing apple with apple. I personally prefer ebit after reading too much of the internet companies using ebitda to justify their lofty valuations during the internet bubbles in the early 2000. This is because I prefer free cash flows, or the actual cash I receive after all costs of doing business plus any reinvestment cost.

2014-03-31 10:54

stockoperator

In case of FACB is a opportunity cost of investing in a company with good business value it explains the deep discount amidst uncertainty of a company direction or incapability of a company to find a good business for years. It is a discount with good reasons.

2014-03-31 11:26

stockoperator

For the short period of time, 3 company illustrated by KC, namely, Kfima, Prestarianf and Ptaras has recorded 20% return that is what i mean by the opportunity cost.

2014-03-31 11:30

Horsefield

How would u know by investing the above stocks (kfima, ptaras, etc) are the opportunity cost at the time of buying (before it rise 20% return) ? What if the stocks do not move for a year, do it still considered as opportunity cost? in my opinion, opportunity cost can only be optimised by reasonable portfolio diversification & avoid loser (fundamentally).

2014-03-31 12:05

stockoperator

OR FACB might invest cash in a new business and make a loss as management has not demonstrated its capability yet. Try to understand a company by business perspective and it explains as it also guided Warren for past 30 years and Warren always opened his speech by saying so year after year that this is one thing that has guided him. Does it explain the low valuation/below NTA of one-timed Proton and long-timed Kluang? Does it explain the bizzare valuation of ICap? Or Does it explain the high flying high multiple of Amazon or Google or now low-lying Apple? On that note, if the closed end funds of ICap is managed by KC, ha, it might be a premium as the way i look at it from business perspective.

2014-03-31 13:48

stockoperator

Surely, it does also explains why Boilermech and QL is outperforming than its peers.

2014-03-31 13:51

stockoperator

For FACB again, Market has amazing ability to discount all your cash on hand for the time being. The question is of good reasons or bad reasons? I am not that of interested as too many cash rich company, too many undervalued company, too many good profit making company, too many good management company, too many Good yield without Good Business. TO me pricing is secondary. Show me the Good business.

2014-03-31 14:23

stockoperator

You might make it Big in FACB this time, who knows and forget what I say. So what you will do next is to continue to look for companies like this day and night.I wish you don't go on this way. I rather prefer you lose out this time.

2014-03-31 14:36

stockoperator

Prove that holding on Good business is a generation wealth and as solid as Gold and lasting as land value. Pass it then to next generation. Then the purpose is done.

2014-03-31 14:54

stockoperator

Lets see KC would one day take up the challenge of managing a fund for all of us.

2014-03-31 15:14

ping

kc, thanks for the clarification :)

2014-03-31 15:26

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