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Monday, 8 December 2008

Enterprise value is negative... Is that possible?

Posted on 12:26 by Unknown
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.
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