Calculating cost of equity for a company with negative book equity
I'm doing a valuation on a privately held company with a negative book value of equity. The equity is negative because the company is in its early years, but has already distributed far more than its initial contribution+earnings.
The ability to make distributions comes from another line of business as well as the fact that they have a contract in place that basically guarantees steady cash flows for the next few years. Since these projections are readily available and reliable, I am using the discounted cash flows method to value the company.
However, this is a private company in a very unique industry, comps are hard to come by. Therefore, I can't model the weight of equity based off of market capital structure. If I only weight cost of debt, the discount is way too low and the company is overvalued. Obviously if they are still making distributions and if I am valuing the company's equity it can't have zero value currently...
Is there a standard method to find the percentage of WACC that goes to cost of equity in this case?
At the moment, I am considering taking the average EBITDA multiple of two industries that this company falls into. After determining the EV I have subtracted debt to get a current value of equity. My D/E ratio ends up being something like 5 to 1
Can't you just use a comp beta unlever it and relever it and use the CAPM
Well yeah I did that and I am using CAPM, but what I can't figure out is what percentage to weight towards equity and what percentage to weight towards debt
I might be woring but isn't WACC calculated using target capital structure and not current capital structure? I seem to remember reading this during my CFA exams. I would come up with a target capital structure and use those weights.
That's actually an interesting point. I believe if you are going to use a target capital structure, you need to be fairly certain that will be the case and a strong argument needs to be made. Obviously I can't use the current capital structure anyway so the question becomes how do I reasonably estimate target capital structure?
Most people would say use the market value of equity as a target value, and I'm beginning to think using the average of two industry EBITDA multiples gives me the closest thing to a market value of equity for this company but I was just curious if anyone had any other input.
If you are using a CAPM to derive your CoE, use the average cap structure of the comps for your company.
My mistake I didn't mean to say I used CAPM, we used a build up method. I don't think it is reasonable to assume the capital structure is the same as the "industry" where this company would be grouped, and that's why I've been having such a dilemma
If you are going to base the capital structure using the actual company's fair market value and debt level, you can use an iterative approach to determine.
Well, I'm looking at it this way: I could only include cost of debt (0% equity) in the discount rate, in which case it will be very small and the company will be vastly overvalued. Or I can use the industry wide average of 50% equity, 50% debt, but like I said, this company's line of business is very unique. There are really no companies in a comparable state that conduct the same type of business activity. 50% equity is unreasonable for a heavily debt financed company and then it will be overvalued.
Ideally, it should be somewhere in between those two extremes and what I still haven't been able to determine is how to get to this %. I'm still thinking that averaging out EBITDA multiples from a few slightly comparable industries to get market value of equity is my best bet, but I'm not sure.
What is an iterative approach?
Undervalued* at 50%. Not overvalued
So is a company worth more if it 100% financed with debt, and 0% equity, compared to a company with 100% equity? Use a target industry group/comp set for cap structure. Iterative: Use what you believe the value of the company to be in determining the cap structure, and see if that makes sense. Set the cap structure so that it will equal your value, and check.
In this case yes, with the build up method resulting in a cost of equity much higher than the going interest rate on debt so the discount rate ends up being much smaller with 100% debt. But that's a flawed valuation.
Would you say that using an industry EBITDA multiple and determining market value of equity from there will be a fair valuation of the company's target equity? This ends up with a roughly 80/20 split in debt to equity and gets me the final value that I think is accurate, but I want to make sure this is justifiable.
I think it would be hard to argue that an industry EBITDA multiple is a good determination of value for your company but their capital structures wouldn't work because your company is in too much of a niche. That makes no sense to me. The industry EBITDA multiple implies a certain WACC which is made up of a capital structure. By using the EBITDA multiple you are justifying the industry cap structure.
ignore, didn't read all
EDIT: either someone has an itchy trigger finger or misinterpreted my comment, i had written something before, hence the "ignore", which didn't make sense and i hadn't read it all.
talk to the current shareholders of the company, assuming it's small enough that it's possible, and get the rate of return at which they will pull their money out or their opportunity cost of investing in the company.
What is the multiple? Say it is 5x. This implies a 20% Cost of Capital. Now configure your cap structure to fit to that. That is what I would do.
Can you explain how that 5x implies 20% cost of capital?
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