Typically when people discuss about stocks and shares, few key parameters discussed are Price earnings and Market Capitalisation.
Market capitalization in simple terms is the cost of buying all the shares of the company or the cost of buying the Company. In a hypothetical case, in the case of two companies whose market capitalization is the same we may come to the conclusion that both the Companies are valued same. Major fallacy in coming to such a conclusion is the fact that the two companies could be leveraged quite differently, that is one Company could have a borrowing of say 1 times the equity and the other Company may be debt free.Buying shares of a company means that one is buying in effect all the assets of the Company but also take over the liabilities of the Company. True cost to an investor would be the cost of acquisition of a debt free company. A company say whose market capitalization is Rs 2000 Crs with a debt of say Rs 1000 Crs. The total cost of debt free acquisition to an investor would be Rs 2000 Crs+Rs 1000 Crs= Rs 3000 Crs
Take the case of another Company which also has a market capitalization of Rs 2000 Crs but is total debt free. The cost of acquisition or the true enterprise value of this Company is Rs 2000 Crs.
Just to give a very simple example let us take the case of One Hotel Company ,A, which has a market capitalization of Rs 200 Crs plus it has a debt in the books of Rs 100 Crs and exactly similar Hotel in another Company B , let us say has a market capitalization of Rs 250 Crs but has no debt. The numbers which are to be compared to is A is valued at Rs 300 Crs (mkt cap of Rs 200 Crs plus debt of Rs 100 Crs whereas B whose market cap is Rs 250 Crs and has no debt would have a total value of Rs 250 Crs
If the performance of the Company B is as good as Company A, one can safely conclude that Company B comes cheaper to the Investor.
Enterprise value , is the value of the enterprise , without any debt. Such an enterprise needs to run the enterprise both capital assets or Fixed capital as well as certain amount of working capital (net current assets ) .The convention to arrive at enterprise value from market capitalization is to add the long term debts and deduct the cash and cash equivalents . But in the practical world , we have seen that net current assets can not be taken as a given and as something which is the same for similar enterprises. It may even a good idea to add the net current assets to arrive at the enterprise value.This may be departure from conventions but a fair comparison to arrive at the respective values of enterprises with different net current assets.Correct method would be to leave out the theoretical requirement of net current assets and add or deduct (adjust ) for the balance over and above the theoretical requirement to the market capitalization to arrive at the enterprise value.
We can look at examples and also may be look at analysis of companies based on enterprise values and profits in a subsequent discussion.
When we talk of comparison of two companies based on their Enterprise values, the bottomline comparison which would be most appropriate would be Profit before Interest . More in next discussion.
S.Srikanthan
CAclubindia
