Archive for the 'Intrinsic vs Enterprise Value' Category

Enterprise Value is a term that is closely related to Intrinsic Value and, depending on usage, the two expressions could be used interchangeably.   Let me focus though on the term Enterprise Value as it pertains to a public company.

Enterprise Value = Equity Value + Net Indebtedness

Equity Value = Shares Outstanding * Price Per Share

Net Indebtedness = Debt Outstanding less Cash Balance

For a public company, Enterprise Value is tabulated every day.  Enterprise Value can be viewed as the stock market’s then-current estimate of Intrinsic Value.  It represents the consensus opinion of all those who bought and sold the stock a particular day as to what the enterprise’s Intrinsic Value.

Recall, though, that Intrinsic Value is defined not as an estimate of an enterprises’ value.    Instead, Intrinsic Value is the true value of the business, and will reveal itself as the true cash flows over time become known.

The delta between Intrinsic Value and Enterprise Value can be viewed as the inaccuracy of the stock market’s consensus estimate on a particular day.   A long-term investor, such as Warren Buffett, does well if he or she can deduce when a wide delta exists between Intrinsic Value and Enterprise Value.  The wider the delta, the more lucrative it is to either buy or sell.

A management team performs best when they have better knowledge of Intrinsic Value than the stock market.  To understand why, let’s consider the alternatives.

  1. One alternative is the management team’s best estimate of Intrinsic Value is the stock market’s daily estimate.  We all know the stock market is fickle and their best guess is subject to wild swings.  If the management team’s understanding is linked to the market’s daily consensus, management’s decision-making criteria will also be volatile.
  2. The second alternative is the management team’s best estimate is inferior to the stock market.   Perhaps this creates more stable decision-making environment.  However, the basis for decisions is concerning, as it is predicated on management having a lessor understanding of the cash flows that will result from their decisions than the collective view of the stock market.  It is hard to see how anything good can come from this.
  3. The third alternative is that management team must rely on an averaging of the stock market’s view over multiple weeks or months.  This normalizes for daily volatility, and hence is better than #1.  And it is certainly better than #2.  Nonetheless, this third alternative doesn’t compare well to a management team that has a superior (relative to the stock market’s) understanding of future cash flows.

Is it a realistic expectation that a management team have a better understanding than the stock market?  The short answer is “absolutely yes”.   I qualify this with a word of caution.  Nearly all management teams believe they have this ability; yet it is unclear how many really do.