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Sure! Think about two companies that just started up in the widget business, each raising $1 million of capital. Company A issued $1 million worth of equity. Co

Sure! Think about two companies that just started up in the widget business, each raising $1 million of capital. Company A issued $1 million worth of equity. Company B issued $500,000 worth of equity and borrowed $500,000. Which company is more valuable? Obviously both are worth the same amount: each company has an "enterprise value" (the value that all investors in all securities place on the underlying enterprise) of $1,000,000. The only difference is that company A has only one class of investor, while company B has investors that own a riskier asset (the equity) and a less risky asset (the debt). But assuming the two companies are otherwise identical, an investor in company B can easily financially engineer themselves into a financial position that is identical to an investor in company A: for every dollar of company B equity they buy, they simply buy one dollar of company B debt. Owning $1 of company B equity and $1 of company B debt is identical to owning $2 of company A equity. Since the choice of equity or debt financing is (theoretically) arbitrary, when comparing two companies that have very different capital structures, like Ford (mostly debt-financed) and Tesla (mostly equity-financed) you have to control for those differences. The simplest way is the add the value of each company's net debt to the market value of their equity, which gives you the total market value of each underlying enterprise. A simple example we're all familiar with is home prices. Two neighbors might own nearly identical houses on the same block in the same town. One might have a mortgage and one might own it outright. But no matter the financial situation of the individual owners, the value of the two houses should be about the same: the value of the asset is separate from the financing of the asset.

robzyb 10y ago
> Obviously both are worth the same amount: each company has an "enterprise value" (the value that all investors in all securities place on the underlying enterprise) of $1,000,000. The only difference is that company A has only one class of investor, while company B has investors that own a riskier asset (the equity) and a less risky asset (the debt). There's an important issue that you aren't taking into consideration. The value of the equity is ultimately based on the profit that remains after interest/debt has been paid. In your example, it is perfectly valid (if not MORE valid) to say that Company A is worth more than Company B. The investors in Company B figured that at the end of the day they will only be eligible for half the cash that investors in Company A will be eligible for. So they paid a lower price. You're insisting that debt is another form of investment, and depending on what you're looking at that makes sense, but when talking about 'value' it doesn't always hold true.
- peterbonney 10y ago
  > You're insisting that debt is another form of investment, and depending on what you're looking at that makes sense, but when talking about 'value' it doesn't always hold true. This sort of intuition is seductive, because we're generally told "debt bad, equity good!" But it's not correct, for the very simple reason that debt and equity are, in many ways, fungible: each type of financing can be utilized to replace the other. To go back to the company A & B example: Company A could decide tomorrow to borrow $500,000 and buy back $500,000 worth of stock. Company B could issue $500,000 worth of stock and pay down its debt. Then, just by shuffling some papers around, the capital structures of the two companies will have been reversed! Yet nothing in the underlying business will have changed for either of them. But don't just take my word for it! Franco Modigliani won a Nobel Prize for his part in the Modigliani-Miller theorem, sometimes called the "capital structure irrelevance principle" (seriously): https://en.wikipedia.org/wiki/Modigliani–Miller_theorem https://en.wikipedia.org/wiki/Modigliani–Miller_theorem It's certainly a complicated subject, but debt is very much a real part of a company's capital structure and can't be ignored when comparing two different companies.
  - robzyb 10y ago
    > This sort of intuition is seductive, because we're generally told "debt bad, equity good!" But it's not correct, for the very simple reason that debt and equity are, in many ways, fungible: each type of financing can be utilized to replace the other. Debt can be viewed in many ways. I'm not saying that it's wrong to view debt as another form of financing - like you I studied Modigliani-Miller, just that there are other ways to view it. My point is only that it's not right to disregard market cap entirely in preference to EV. EV is generally a "more comprehensive" measure of company value, but it doesn't supersede market cap. EV, for example, is susceptible to distortion between leasing and buying capital assets. For example, a company with big capital assets financed via debt could note that the company would be more profitable if they sold them and leased them back. The company is now more profitable, and its reasonable to say its 'better', but its EV has gone down.
    - peterbonney 10y ago

robzyb 10y ago

> Obviously both are worth the same amount: each company has an "enterprise value" (the value that all investors in all securities place on the underlying enterprise) of $1,000,000. The only difference is that company A has only one class of investor, while company B has investors that own a riskier asset (the equity) and a less risky asset (the debt). There's an important issue that you aren't taking into consideration. The value of the equity is ultimately based on the profit that remains after interest/debt has been paid. In your example, it is perfectly valid (if not MORE valid) to say that Company A is worth more than Company B. The investors in Company B figured that at the end of the day they will only be eligible for half the cash that investors in Company A will be eligible for. So they paid a lower price. You're insisting that debt is another form of investment, and depending on what you're looking at that makes sense, but when talking about 'value' it doesn't always hold true.

peterbonney 10y ago
> You're insisting that debt is another form of investment, and depending on what you're looking at that makes sense, but when talking about 'value' it doesn't always hold true. This sort of intuition is seductive, because we're generally told "debt bad, equity good!" But it's not correct, for the very simple reason that debt and equity are, in many ways, fungible: each type of financing can be utilized to replace the other. To go back to the company A & B example: Company A could decide tomorrow to borrow $500,000 and buy back $500,000 worth of stock. Company B could issue $500,000 worth of stock and pay down its debt. Then, just by shuffling some papers around, the capital structures of the two companies will have been reversed! Yet nothing in the underlying business will have changed for either of them. But don't just take my word for it! Franco Modigliani won a Nobel Prize for his part in the Modigliani-Miller theorem, sometimes called the "capital structure irrelevance principle" (seriously): https://en.wikipedia.org/wiki/Modigliani–Miller_theorem https://en.wikipedia.org/wiki/Modigliani–Miller_theorem It's certainly a complicated subject, but debt is very much a real part of a company's capital structure and can't be ignored when comparing two different companies.
- robzyb 10y ago
  > This sort of intuition is seductive, because we're generally told "debt bad, equity good!" But it's not correct, for the very simple reason that debt and equity are, in many ways, fungible: each type of financing can be utilized to replace the other. Debt can be viewed in many ways. I'm not saying that it's wrong to view debt as another form of financing - like you I studied Modigliani-Miller, just that there are other ways to view it. My point is only that it's not right to disregard market cap entirely in preference to EV. EV is generally a "more comprehensive" measure of company value, but it doesn't supersede market cap. EV, for example, is susceptible to distortion between leasing and buying capital assets. For example, a company with big capital assets financed via debt could note that the company would be more profitable if they sold them and leased them back. The company is now more profitable, and its reasonable to say its 'better', but its EV has gone down.
  - peterbonney 10y ago