Hi,
I recently finished my analyst training at a boutique but I feel like several important details/explanations were left out of our training.
For example, why do we look for the market value of debt, preferred stock, and minority interest when backing into equity value from enterprise value?
If a firm only has bank debt that is not trated and thus has no market value, why do we insist in estimating its market value?
I have heard reasons such that market values are important from an acquisition perspective, but that still doesn't explain why we look for the market values of non-traded debt or minority interest (which is irrelevant in a deal context).
From my understanding, any increase in market value of assets should be reflected in higher equity value and not in other claims on assets like debt and preferred.
What am I missing here?
I didn't fully catch your last point but essentially when backing into equity value from total enterprise value you are trying to understand the equity claim of equity stakeholders in real-time on a forward or future looking basis.
You have to assume the equity value is fully adjusted based on all known public information and since that is forward looking you must all ensure the other side of the coin is forward looking too. Otherwise not apples to apples.
Thanks, but I'm still not sure why we look at the market value of non-traded liabilities like bank debt or non-traded preferred?
Their claims on assets don't change from what is stated on the B/S, correct?
Just to add another point (and hopefully someone can reply), the present value of non-traded bank debt to a company is the book value on its balance sheet, right?
If the company decided to repay all of its debt today, it would do so at the book value and not the market value.
So why is the market value of debt so important?
Book value of debt is not necessarily present value... Book value would be face value unless formally some type of write down has been realized for accounting purposes. Book value is not necessarily a reliable indicator of how much they company actually owes to a bank. lets say your valuing a company on the brink of bankruptcy, they have debt listed at book... u know you're going to be able to negotiate with the bank so they take a hair cut on part of the debt, thus leaving you more equity value... you need to adjust for the assumption of the haircut. Otherwise TEV is huge and EV would be non existent.
Sorry I can't really explain your question better perhaps someone else has a more academic insight on this matter?
Thanks for the replies Canadian Monkey.
But here's my question. Imagine we're looking at a company with $100 million in bank debt at 8% and $200 million in outstanding bonds at 10% YTM.
If we use that same YTM to turn the bank debt into "market value," we're implicitly saying that we could acquire that debt for less than its book value, right?
But as far as I know, that is neither true for an acquirer or for the target company.
Can someone please elaborate?
If you have a company worth $300 TEV with $200 face value debt, but that debt is worth $100 in open market, then if you value the equity at $100, then a smart investor will buy the equity at $100, take out a loan to purchase the debt for $100, and create $100 of equity value - this is obviously a perfect world situation, but that's why equity value must reflect market value of debt when using TEV, because that arbitrage would never exist.
What makes market value deviate from face value is 1) yield and 2) probability of default. As a prospective equity holder, you would rather have below-market debt than equal or above (e.g. no interest vs 10% interest). As such, you must reflect that in your equity valuation, which is what is captured by using market value of debt. The second and larger piece of the market value equation (default) is not typically accounted for in a non-distressed M&A transaction because if you are purchasing the equity, then presumably there is enough collateral through the debt.
For a going concern, there are a number of mechanisms to adjust market value to its real market value, including debt buybacks / open-market purchases. While there may be covenants that prevent the company itself from doing so, presumably third-parties will right the market value if transaction costs / transaction premiums are not prohibitive.
As an aside, bank debt, while it may not be publicly traded, can still be purchased and sold among institutions.
monkeynumber7, thanks a lot for the answer.
However, I still respectfully disagree on a few notes. First, while the "intrinsic value" of equity may be subjectively determined by a potential acquirer, the actual value or price he/she willl have to pay will be set by the market (assuming public company).
Second, I think that the relevance of using market values for debt instead of book values differs depending on if we're doing a stand-alone valuation versus a M&A valuation.
Lastly, even if we're valuaing a potential target, whether market values are even relevant will depende on the characteristics of the debt in question. For publicialy traded bonds, sure. For bank debt that will be assumed and serviced, I don't see the point of using market values still.
My whole point is that some analyses I see make silly assumptions about the market values of debt for companies that almost entirely have bank debt on their books. Same goes for private companies.
I know bank debt may in some cases by traded among institutions, but that is hardly a reason to use market values instead of book values for all companies.
I'm still confused about this issue.
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