Table of Content
CHAPTER 14: THE MILLION DOLLAR QUESTION: HOW MUCH TO PAY FOR IT?

Previous Chapter
The Concept of Enterprise Value
Next Chapter

CHAPTER 14: THE MILLION DOLLAR QUESTION: HOW MUCH TO PAY FOR IT?

The Concept of Enterprise Value

Enterprise Value is a measurement of the real economic value being assigned to a company.

The standard value of a company is the market capitalisation of the company (which as explained in the earlier chapter, is derived by multiplying the number of shares with the share price). However, this is not the true value of a company in the standpoint of investors.

Take the example below for instance.

Table 3: Financial Data of Company A

 Net profit (RM) 10,000,000 No. of shares outstanding (shares) 20,000,000 Share price (RM) 2.00 Total debts of Company A (RM) 50,000,000 Total cash held by Company A (RM) 30,000,000

Market capitalisation of Company A

= No. of shares outstanding x Share Price

= 20,000,000 shares x RM2.00

= RM40,000,000

By investing in Company A at RM2.00 per share, investors are giving Company A a market capitalisation of RM40 million. However, when an investor invests in Company A, investors are also “taking on” the debts of Company A. It is the same concept as a takeover. If say Company B buys Company A, Company B will be liable for the debts of Company A.

So how much are investors actually paying for Company A? Since investors will be “taking on” the debts of Company A, investors will also “share” the cash that Company A holds.

Thus, the value that investors are paying for Company A would be RM40 million adding on debts of RM50 million and deducting cash worth RM30 million, which equals to RM60 million. And this RM60 million is the Enterprise Value of Company A.

 Enterprise Value = Market Capitalisation + Debts – Cash & cash equivalents

Some would extend the definition of debts to include preferred shares and minority interest.

If we change the PE ratio formula to Enterprise Value-to-Earnings, or EVE ratio, the new multiple would be:

Enterprise Value-to-Earnings ratio:

= Enterprise Value ÷ Earnings

= RM60,000,000 ÷ RM10,000,000

= 6x

Based on EVE approach, investors are actually paying 6x multiple over Company A’s earnings, as opposed to the 4x multiple derived using the PE approach. Thus, if one only relies on PE, a company may look cheap, sound cheap, but may not actually be cheap.

One of the stocks that can be used as a case study in this case would be Engtex Group Bhd (“Engtex”). Table 4 shows the financial highlights of Engtex.

 Table 4: Engtex Financial Highlights (in RM million) 2012 2013 2014 2015 2016 Net profit 29.2 51.2 53.6 40.4 59.2 Long-term loans & borrowings 39.9` 85.9 127.2 155.3 146.6 Short-term loans & borrowings 276.5 300.7 362.4 337.7 378.1 Total loans & borrowings 316.4 386.6 489.6 493.0 524.7

From 2012 to 2016, the highest historical PE recorded by Engtex was 9.57x on 15th January 2016 whereas the lowest was 3.34x on 3 May 2013. One may wonder why despite such good profit performance, Engtex trades at such low valuation?

The reason lies with Enterprise Value. At the point of writing, Engtex has a market capitalisation of RM327 million. This means that based on 2016 profit, Engtex is trading at historical PE ratio of 5.5x. However, taking into consideration the group’s loans, Engtex is trading at Enterprise Value of 14.4x.

Next week, we will take a look at the second valuation approach, which is Dividend Yield approach.