Market Capitalisation Vs Enterprise value

Market Capitalisation Vs Enterprise value

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 deduct  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 to the market capitalization.

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.

Compounding and Annuities

Most of us would have heard the cliched "magic of compounding". The magic is  in the fact that the growth of an investment is exponential and not quite the linear grwoth that is generally experienced where  simple interest is worked out . The reason lies in the fact that the Interest is added to the base principal at regular intervals and that forms the basis for further Interest calcuation

Say at interest of 10% per annum, an investment of Re 1 at the beginning of year 1 , would becomes 1.1 at the end of year 1, in generic way it can be expressed as (1+i)

And at the end of say 3 years the same would be (1+i)^3 and at the end of n years, the same would be 

A =P(1+i)^n

A bit more complicated would be to ascertain the value of an  Annuity or the maturity value of a regular payment at a regular intervals at a regular rate of interest . The derivation is through a summation of a geometric expression and the simplified form is as follows

Sn     = R *{(1+i)^n  - 1}/i   where

Sn is the Annuity or the maturity value

R is the regular payment at regular intervals and 

i is the rate of interest at the intervals specified

Of course one assumption in this is that the amounts are either invested at the end of the regular interval and say the first investment earns interest for (n-1) year and the last regular investment - no interest.

A variation of this is where the regular payment is at the beginning of the interval and earns interest for the full quantum of n years/months as the case may be and the last one also earns interest for on year would be as follows.

Sn   = R * { {(1+i)^(n+1)}-(1+i)}/i

Rule of 72

 Rule of 72

 “Rule of 72” is a simple  rule of thumb to determine the number of years it takes for an investment at a certain rate of interest ( interest at annual rests) to double. As is the case with most thumb rules, it works well within a certain “normal” data range.One can use the same to determine the implicit interest rate given the amount invested and the maturity amount.

To illustrate the use of it, let us assume that an investment is made at 8% per annum and at yearly rests, it would take 72/8=9 years for it to double. The underlying assumption is that the annual return is reinvested at the same rate of interest .This rule works well within an interest range of 5% to 12% with best being at 8% 

(Not able to attach an excel table. Not quite sure how to do the same)

Just as when one is given a rate of interest, one can find the no of years it takes for the investment to double by dividing 72 by the rate of interest, given the fact that an initial investment doubles in a certain no of years, one can find the underlying rate of return .

If someone says that an investment doubles in 9 years, then the underlying annual return rate is 72/9= 8%.