Leveraged companies versus cash rich companies

[krishan]

Just thought I'd write a quick primer since some of the forum has invested in DSUP and you really need to understand leverage to understand how DSUP has performed recently and what could happen in the future.

EV is the total price of a company including cash/debt. The reason this can be a better foundation metric is because it more accurately portrays the value of a company independent of the capital structure. Assume two companies sell the same product. Company S has a 10M market cap, and company T has a 100M market cap. Is one bigger than the other? Depends on the debt levels at each company. If T has no debt and S has 500M in debt company S would be the larger company. It doesn't make sense to compare the companies on a market cap basis.

EV is paired most often with EBITDA for valuation purposes. EBITDA is the operating profitability of a company before interest, taxes, and non-cash charges depreciation/amortization. Two companies with 500M EV should have similar EBITDA generation capabilities. The fact that a lot of EBITDA will be used to pay interest/debt isn't necessarily relevant. Companies with lower EBITDA margins regardless of capital structure tend to be worse companies and be given lower EV/EBITDA multiples.

Leverage in this context is important because it magnifies the potential upside and potential downside. Cash

Company A has 10M shares at 10 bucks, the market cap is 100M. With 0 debt and cash, EV is also 100M.

Company B has 10M shares at 5 bucks with 50M in debt. Market cap is 50M but EV, the total cost of the company is 100M same as Company A.

Company C has 10M shares at 20 bucks with 100M in cash. 200M market cap but a 100M EV because you have to subtract the cash from the market cap to come up with true price of the company.

Assume all 3 companies generate 10M in EBITDA annually (10x EV/EBITDA multiple). Suddenly due to market demand, they are all able to do 20M in EBITDA. What happens to the stock price of each company assuming a consistent 10x multiple?

Company A will trade at 20$ for a 100% return on the $10 stock price.

Company B will trade at an EV of 200. The debt remains at 50M so the stock price rises from $5 to $15 a 200% gain.

Company C trades at an EV of 200 but because of the cash, the stock price doesn't move as much. Stock price moves from $20 to $30, a 50% gain.

On the flip side, if EBITDA contracts 50% the leverage hurts you the most.

Company A trades at $5 a 50% reduction in value.
Company B trades at $0. 100% loss of value, equity is wiped out.
Company C trades at $15, a 25% loss of value. The cash cushions the fall.

So DSUP is highly levered. ~100M MC and 330M in debt for a total EV of 430M. The stock price can drop from 14-8 or 8-5 without a large decrease in EV due to leverage. No downside protection with heavily leveraged companies.

I'm fast becoming a fan of cash rich companies. In particular cash rich companies whose stock is down dramatically. Because of the cash, stock price decreases can dramatically change the EV of a company making it significantly more attractive. CUTR is an example of this. If a leveraged company decreases in value it's not a huge change.

Just wanted to post some thoughts.

Krishan

[Jimbo]

If you are saying to never buy a stock just because it has been touted on a message board I agree.

Jimbo

[PRE]

I think it's also important to take into account what the company regularly does. I invest in companies with 55% - 60% net debt-to-capital and it's not risky at all due to the consistent operations that they're involved in.

Leverage increases return, but at the same time risk. This isn't what's important; what's important is whether or not the return outweighs this risk. This is where value can be added.

EV/EBITDA is a very good metric, but it's widely used by just about every analyst now, so I don't think you can get as much out of it as once posible.

*The most important thing when looking at a potential investment is thinking about what will drive its stock price in the future. Too many people focus on historical numbers. Who cares? Find metrics like EV/EBITDA once was that helps you identify signs of potential future growth.

[stinkypete]

[ QUOTE ]
Company A has 10M shares at 10 bucks, the market cap is 100M. With 0 debt and cash, EV is also 100M.

Company B has 10M shares at 5 bucks with 50M in debt. Market cap is 50M but EV, the total cost of the company is 100M same as Company A.

Company C has 10M shares at 20 bucks with 100M in cash. 200M market cap but a 100M EV because you have to subtract the cash from the market cap to come up with true price of the company.

[/ QUOTE ]

this isn't quite how it works. you can't just add debt and market cap and get the "EV" of the company - the more leveraged the company is, the more incorrect this becomes.

think of the stock as a call option on the company's net worth, where the strike price is the company's total debt. if the company's total value drops below the total debt and the company goes into bankruptcy, the "option" expires worthless.

company B in your example has a 50M market cap and 50M in debt. by owning shares your downside is limited to the first 50M - if the value drops below 50M you can't lose any more. but your potential for upside is big, as you mentioned.

a call option whose underlying stock is trading slightly above the strike price will actually be worth much more than the stock price minus the strike price. the same concept applies to leveraged companies.

using your pricing method, the cash rich companies will seem undervalued relative to the leveraged companies - but that's because it undervalues the leveraged companies.

[ozyman]

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[ QUOTE ]
Company A has 10M shares at 10 bucks, the market cap is 100M. With 0 debt and cash, EV is also 100M.

Company B has 10M shares at 5 bucks with 50M in debt. Market cap is 50M but EV, the total cost of the company is 100M same as Company A.

Company C has 10M shares at 20 bucks with 100M in cash. 200M market cap but a 100M EV because you have to subtract the cash from the market cap to come up with true price of the company.

[/ QUOTE ]

this isn't quite how it works. you can't just add debt and market cap and get the "EV" of the company - the more leveraged the company is, the more incorrect this becomes.

think of the stock as a call option on the company's net worth, where the strike price is the company's total debt. if the company's total value drops below the total debt and the company goes into bankruptcy, the "option" expires worthless.

company B in your example has a 50M market cap and 50M in debt. by owning shares your downside is limited to the first 50M - if the value drops below 50M you can't lose any more. but your potential for upside is big, as you mentioned.

a call option whose underlying stock is trading slightly above the strike price will actually be worth much more than the stock price minus the strike price. the same concept applies to leveraged companies.

using your pricing method, the cash rich companies will seem undervalued relative to the leveraged companies - but that's because it undervalues the leveraged companies.

[/ QUOTE ]

In the OP, "EV" meant Enterprise Value EV - Enterprise Value

[stinkypete]

[ QUOTE ]
[ QUOTE ]
[ QUOTE ]
Company A has 10M shares at 10 bucks, the market cap is 100M. With 0 debt and cash, EV is also 100M.

Company B has 10M shares at 5 bucks with 50M in debt. Market cap is 50M but EV, the total cost of the company is 100M same as Company A.

Company C has 10M shares at 20 bucks with 100M in cash. 200M market cap but a 100M EV because you have to subtract the cash from the market cap to come up with true price of the company.

[/ QUOTE ]

this isn't quite how it works. you can't just add debt and market cap and get the "EV" of the company - the more leveraged the company is, the more incorrect this becomes.

think of the stock as a call option on the company's net worth, where the strike price is the company's total debt. if the company's total value drops below the total debt and the company goes into bankruptcy, the "option" expires worthless.

company B in your example has a 50M market cap and 50M in debt. by owning shares your downside is limited to the first 50M - if the value drops below 50M you can't lose any more. but your potential for upside is big, as you mentioned.

a call option whose underlying stock is trading slightly above the strike price will actually be worth much more than the stock price minus the strike price. the same concept applies to leveraged companies.

using your pricing method, the cash rich companies will seem undervalued relative to the leveraged companies - but that's because it undervalues the leveraged companies.

[/ QUOTE ]

In the OP, "EV" meant Enterprise Value EV - Enterprise Value

[/ QUOTE ]

i wasn't aware of this term, but that doesn't change my argument. the enterprise value is still a poor measure of "true price" for the reasons i mentioned.

[DesertCat]

[ QUOTE ]


this isn't quite how it works. you can't just add debt and market cap and get the "EV" of the company - the more leveraged the company is, the more incorrect this becomes.


[/ QUOTE ]

EV (enterprise value) is a good theoretical framework for comparing companies with wildly different capital structures. I can't see how thinking of shares as call options is as useful or accurate.

First, EV is simple to use. Second, shares have valuable features that options don't have.

1) Stocks provide voting rights.
2) Stocks provide a claim to cash flows, primarily as dividends.
3) Stocks never have an expiration date.

Of course EV often does overvalue cash rich companies, because dead cash on a balance sheet isn't as useful as cash in your pocket. Whitman's "Value Investing" is all about the importance of capital structure as a determinant of value, and the importance of where you lie in that structure and how much influence you can or need to have to determine what the real value of your investment is.

[stinkypete]

think about it this way.

say a company has 100M in debt while it's "worth" 101M based on assets, expected future cash flows, etc.

does this mean the shares should be worth 1M? no. the shares should be worth a lot more than that, because the downside is only 1M while the upside is huge.

the enterprise value of this company will be much higher than 101M, even though its assets and future cashflows only justify a valuation of 101M.

on the other hand, the debt will be worth significantly less than its face value of 100M due to the default risk. if you add the market value of the debt to the market value of the shares, you should get the "true value" (101M) of the company - this will be less than the "enterprise value", which will be 100M + market cap.

[DesertCat]

[ QUOTE ]
think about it this way.

say a company has 100M in debt while it's "worth" 101M based on assets, expected future cash flows, etc.

does this mean the shares should be worth 1M? no. the shares should be worth a lot more than that, because the downside is only 1M while the upside is huge.

the enterprise value of this company will be much higher than 101M, even though its assets and future cashflows only justify a valuation of 101M.

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A company's intrinsic value is different than it's enterprise value. Enterprise value is essentially the market value of the company's shares and net debt. IV is what you think it's worth, and the existence of $100M in debt creates both opportunities and risks.

But I understand what you are saying about the optionality of the common. I usually just think of it as a binary situation, and handicap the likelihood of a zero result vs. a positive result ("in the money"). So similar to options, except you wouldn't use beta to calculate the odds of ending "in the money", you would use business risks and prospects.

[ QUOTE ]

on the other hand, the debt will be worth significantly less than its face value of 100M due to the default risk. if you add the market value of the debt to the market value of the shares, you should get the "true value" (101M) of the company - this will be less than the "enterprise value", which will be 100M + market cap.

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If debt can be repurchased cheaply, it's reasonable to use the value of debt instead of it's face value in a EV calculation. Level III is an example of a company that keeps putting itself in bad positions that allow it to buy back it's own debt at a big discount. But you can't use market value directly, if the debt is trading at 50 cents on the dollar, it's probably going to cost 65 cents or so in a tender offer.

[jumbojacks]

Thanks for the post krishan.