Though a company’s capital structure includes both equity and debt, market cap does not reflect debt.
Bob Auer
Some commonly used financial terms are commonly misunderstood. Such is the case with “market capitalization,” which refers to a figure widely believed to represent a company’s value.
Yet, unbeknownst to many individual investors (and some advisors), this conception of the term is misguided because market cap only tells half the story of a company’s actual value.
Nevertheless, in company descriptions and summaries, “market cap” is ubiquitous. Everywhere you look — in media articles, on brokerage websites, on cable financial channels and in financial columns — you see references to it.
Market cap is calculated by multiplying the share price by the number of outstanding shares. The financial industry uses this figure to indicate a company’s size, designating it as small-, medium- or large-cap. A company’s market cap is widely assumed to be an accurate representation of its size because this figure is assumed to represent its total value.
But this assumption is flat wrong for a simple reason: Though a company’s capital structure includes both equity and debt, market cap does not reflect debt. Not one iota of it.
Though you don’t hear about it much, there’s another dollar figure that, if broken down into its component parts, tells investors what they mistakenly believe market cap is telling them. That figure is enterprise value (EV).
Not a reference to electric vehicles, this figure includes the value of a company’s equity and debt. The calculation for EV is:
EV = market cap + total debt – cash.
Total debt is the sum of all short- and long-term debt, most of it, usually, from issuing bonds. Cash means actual cash and cash equivalents — highly liquid assets that aren’t marketable securities. In the formula, cash is subtracted because, unlike much of a company’s debt, cash isn’t currently invested in the enterprise. (Cash is a wonderful thing to have, but companies with large amounts of it might be better off putting it into their businesses somehow.)
For potential corporate acquirers, EV informs assessments of how much a company would cost to purchase. For investors, knowing a company’s EV, relative to its market cap, is critical because over time, debt weighs on earnings, and earnings is the most important factor driving share price.
Though knowing a company’s EV is essential when assessing its stock, it’s widely overlooked by investors. Before looking at market cap, investors should first consider the EV and then compare it with that company’s market cap. If the ratio EV/market cap ratio is a big number, the company probably has a boatload of debt.
If the quotient is close to zero, the market cap accurately represents a company’s value, as it probably has negligible debt — a corporate virtue. If a company has no or little debt but a lot of cash on hand, its EV may be well below its market cap. Low or no debt is generally a good criterion for stock selection.
But having debt isn’t inherently negative; it’s a matter of degree. Most companies naturally have some debt because this is an integral part of running a business.
The strategic need to borrow money varies with the particular industry. Having a lot of debt for a given industry — or just in general — tends to be suboptimal, as it is in your personal finances. High debt is usually a red flag for prospective investors.
Some large, blue-chip companies have EVs at or below their market caps, while others have so much debt that their EVs dwarf their market cap figures.
For example, as of early November, Verizon had a market cap of $148 billion and an EV of $315 billion.
Some other well-known names have scant debt, so their EVs are close to their market caps. As of early November, Apple had a market cap of $2.69 trillion and an EV of $2.72 trillion, meaning little or no debt and probably a lot of cash.
In some industries, EV and market cap comparisons between companies can be revealing.
As of early November, Tesla had a market cap of about $706 billion and an EV of about $685 billion, as the company was apparently net-debt-free.
By contrast, General Motors then had a market cap of nearly $38 billion and an enterprise value of about $126 billion because of high debt. Ford had a similar market cap, about $40 billion, with the albatross of even more debt, which brought its EV to nearly $142 billion. (If GM had entered the recent United Auto Workers strike with an EV close to its market cap, it might have been able to wait out the union. But interest payments coming due on massive bond debt make that strategy infeasible.)
By contrast, Tesla’s low debt propels stock purchases (though many analysts believe the stock is currently over-priced).
Not surprisingly, the stocks of companies with EVs close to their market caps tend to perform better over the long term. Informed investors seek them out and buy them because analysts rate them highly, as scant debt is highly positive for earnings projections.
Unlike a company’s market cap, finding its EV may require drilling down a bit on your brokerage’s website, though a figure of its significance should be readily accessible.
If you don’t see the EV listed, you can usually find it included in analysts’ reports linked from these research pages. However, some financial services firms, like Charles Schwab, display the two numbers with equal prominence on stock research pages on their websites. And many third-party financial websites, such as Yahoo Finance, display EV among other financial stats in tables.
By looking at both figures together, you can get a good idea of how much debt a company has and hence, a more accurate estimation of its actual value.
Robert C. Auer is the founder of SBAuer Funds, LLC, based in Indianapolis, and has served as the Senior Portfolio Manager for the Auer Growth Fund since its inception in 2007. The fund has a strict value discipline—a focus on buying undervalued stocks with significant potential for growth.
Previously, he served as Vice President of Investments for Morgan Stanley. He is a former stock market columnist for the Indianapolis Business Journal, where he wrote more than 400 weekly columns on a wide range of investment topics. He holds a B.S. in business systems from Taylor University.
The companies mentioned in this publication may be held by Auer Funds, LLC or related persons. Therefore, there may be a conflict of interest in that advisors may have a vested interest in these companies and statements about them.
