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> 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

> 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
  > EV, for example, is susceptible to distortion between leasing and buying capital assets. Yes, this is an excellent point. The next-level thing to do when modeling companies that make extensive use of operating leases for capital assets is to capitalize those operating leases, for exactly this reason.
skybrian 10y ago
It seems strange to ignore the terms agreed to when raising money. A company that raises money via loans typically has more obligations than one that raises money via equity. Doesn't the option value for repayment count for anything?
- peterbonney 10y ago
  > It seems strange to ignore the terms agreed to when raising money. I'm not sure what you mean by this - can you clarify? > A company that raises money via loans typically has more obligations than one that raises money via equity. Doesn't the option value for repayment count for anything? Certainly the equity of a highly indebted company will behave differently than the equity of a debt-free company. But "different" isn't necessarily "better". To go back to my company A & B example, if both companies double in enterprise value, the equity holders of company A will get a return of 100% ($1,000,000 profit on capital of $1,000,000), but the equity holders of company B will get a return of 200% ($1,000,000 profit on capital of $500,000). Conversely in a scenario where each company loses half of its value, the equity holders of company A will still be left with half of their money, while the equity holders of company B will be wiped out (to first order - reality is more complicated than this usually). So in some scenarios the company A equity looks better and in some scenarios the company B equity looks better. Which you prefer overall depends on your individual risk preferences - some people want a higher potential return at the cost of higher risk, some people want less risk at the cost of a lower potential return. There's no objectively "best" structure. Even for companies with no debt at all you'll see investors who artificially create financial leverage by buying options on the company's equity. Different strokes for different folks, or as my dad likes to say, there's an a$$ for every seat. :)
  - skybrian 10y ago
    Interesting. Yes, tolerance for risk varies with each investor, but isn't there supposed to be a consensus way that the market prices risk, on average? I'm just throwing out terminology here, but what about "risk-adjusted return"? Other things being equal (which they never are), prices should be lower for higher-risk investments, to compensate for the risk taken. So I'm wondering how enterprise value prices risk compared to market value.

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
> EV, for example, is susceptible to distortion between leasing and buying capital assets. Yes, this is an excellent point. The next-level thing to do when modeling companies that make extensive use of operating leases for capital assets is to capitalize those operating leases, for exactly this reason.

skybrian 10y ago

It seems strange to ignore the terms agreed to when raising money. A company that raises money via loans typically has more obligations than one that raises money via equity. Doesn't the option value for repayment count for anything?

peterbonney 10y ago
> It seems strange to ignore the terms agreed to when raising money. I'm not sure what you mean by this - can you clarify? > A company that raises money via loans typically has more obligations than one that raises money via equity. Doesn't the option value for repayment count for anything? Certainly the equity of a highly indebted company will behave differently than the equity of a debt-free company. But "different" isn't necessarily "better". To go back to my company A & B example, if both companies double in enterprise value, the equity holders of company A will get a return of 100% ($1,000,000 profit on capital of $1,000,000), but the equity holders of company B will get a return of 200% ($1,000,000 profit on capital of $500,000). Conversely in a scenario where each company loses half of its value, the equity holders of company A will still be left with half of their money, while the equity holders of company B will be wiped out (to first order - reality is more complicated than this usually). So in some scenarios the company A equity looks better and in some scenarios the company B equity looks better. Which you prefer overall depends on your individual risk preferences - some people want a higher potential return at the cost of higher risk, some people want less risk at the cost of a lower potential return. There's no objectively "best" structure. Even for companies with no debt at all you'll see investors who artificially create financial leverage by buying options on the company's equity. Different strokes for different folks, or as my dad likes to say, there's an a$$ for every seat. :)
- skybrian 10y ago
  Interesting. Yes, tolerance for risk varies with each investor, but isn't there supposed to be a consensus way that the market prices risk, on average? I'm just throwing out terminology here, but what about "risk-adjusted return"? Other things being equal (which they never are), prices should be lower for higher-risk investments, to compensate for the risk taken. So I'm wondering how enterprise value prices risk compared to market value.