Every company has access to sources of funds - equity and debt. M-cap measures only equity and ignore the debt that a company absorbs. This is what happened in Videocon Appliances case. The uninformed investor's PE calculations is on the basis of an m-cap of just 95 crores and ignores 840 crores of debt. A value investor, on the other hand, would never ignore the debt number.
Increasingly, value is defined as the total funds needed to finance a company (rather than in terms of the PE ratio). This focuses less on returns in relation to accounting, and more on economic returns—in other words, the profits that a company is making on its supporting capital.
Lately, I have started to use a lot of EV analysis. Using enterprise value is often touted as a better approach to valuation, as opposed to just market capitalisation. EV calculations work on the premise that buying a stock is equal to buying a business i.e. the amount you would be paying buying the entire business. This includes the amount of debt the company has on books and subtracts the cash in the company. Thus, EV = M-cap + Debt - Cash
A case in point was Videocon Appliances. (here)
A cursory analysis of financial does make a good reading -
1. The stock is available at a PE of just 5.67. It's nearest competitors are priced much higher (Whirlpool at 20.6, BlueStar at 29.4).
2. The m-cap/sales is at just 7%
3. The company is profitable and is expect to earn about Rs. 17 crores of profits for the year. The operating profit is a huge Rs. 160 crores.
While the stock seems smartly placed for an investor .. EV tells a different story. The EV for Videocon Appliances is about 10 times it's market cap, on account of almost 840 crores of debt it carries on it's books. So as per the EV principle, if you were to purchase 100% of the business you would be paying 96 crs (m-cap) + 841 crs (debt) - 6 crs (cash) = Rs. 931 crores (EV).
The most used metric is EV/EBIT. At 931 crs of EV and an estimated EBIT of 77 crs ... the EV/EBIT comes to 12.10. Compare this with a Whirlpool .. which inspite of a P/E ratio of 20 ... comes at an EV/EBIT of 8.25.
In conclusion, as a buyer of a business ... you have 2 options :
1. Videocon Appl : available at 931 crs ; EBIT of 77 crs ; PE of 5.6 .... or,
2. Whirlpool India : available at 773 crs ; EBIT of 84 crs ; PE of 20
If you like this content, then do check out my new blog on investing and stock markets for lots more information on the Indian equity markets
Which one will you pick? (how useful is the PE ratio here?)
Friday, April 25, 2008
Enterprise value and stock valuations
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2 comments:
The market cap should have included the company debt also right? Why it should be added to market cap to get EV?.
I have no knowledge of EV and am form completely different background.
Anand
Hi Anand,
Think of it this way. You are buying a second-hand car. Now you examine the car at the seller's house, like it and strike a deal at Rs. 3 lacs. What the seller didnt tell you is that most of the engine's parts are worn out and need to be replaced costing about Rs. 60,000. (he doesnt need to tell you this ala .. caveat emptor) .. For you, the right price of the car is now Rs. 3.6 lacs.
So, 3 lacs is just like m-cap and 3.6 lacs is EV. It's best to assume that the market will not tell you about that extra thing called "debt" and leave it upon you to figure that out. This makes EV a more superlative metric.
Now it's not necessary that m-cap will be lesser than EV. In cash rich companies, the EV is lower than the m-cap. Like when I first bought GTL at Rs. 67 per share, the cash in the company was Rs. 64 per share (with no debt). Hence the EV was just Rs. 3 * no. of shares at that time. The EBITDA was higher than the EV then.
You might want to take a look at this page from Gruh Finance Limited, explaining EV.
http://www.gruh.com/pdf/enterprise_value.pdf
Warm Regards
Shankar
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