The Three Measures Of Value

Foreword from ShareInvestor

This article “The Three Measures Of Value” by Teh Hooi Ling was first published in The Business Times on 17 Aug 2013 and is reproduced in this blog in its entirety.

Study the balance sheet to see the distinctions between the different methods, suggests an NYU finance professor

MARKET value of equity, firm value and enterprise value – how do they differ? Early last year, Apple was cited as the most valuable company in history, based on the market value of its equity. Sometime this year, as its share price faltered, the Wall Street Journal said that Google had overtaken Apple. But, this time, enterprise value was used as a measure of value.

Aswath Damodaran, Professor of Finance at the Stern School of Business at New York University (NYU), detailed the differences between the three measures of value in his blog Musings on Markets not too long ago.

FIGURING IT OUT: The value of an asset should always be about the cash flow it is able to generate over its life. PHOTO: YEN MENG JIIN

To see the distinctions between the different measures, Prof Damodaran suggests looking at it in a balance sheet format. In a balance sheet, we have assets of the firm on one side and capital on the other side.

On the assets side, we have cash; other non-operating assets such as buildings; and operating assets like fixed assets (for example machinery), intangible assets such as brand names and working capital.

On the capital side, there are debts, and equity.

Market value of equity is what the stock market is valuing the equity portion of the firm. The conventional practice is to multiply the shares outstanding in the company by the share price to get to a market capitalisation and to use this as the market value of equity.

You can independently arrive at the market value of the equity if you are able to assess the market value of all the firm’s assets and, from there, deduct the market value of the firm’s debts. If the equity value you arrived at independently is higher than the stock’s market cap, then you would deem the stock undervalued.

The second measure – firm value – is the sum of the market value of equity and the market value of debt. Using the balance sheet format again, the market value of the firm measures the market’s assessment of the values of all assets.

The third measure of market value nets out the market value of cash and other non-operating assets from firm value to arrive at enterprise value. With the balance sheet format, the enterprise value should be equal to the market value of the operating assets of the company.

Prof Damodaran highlighted that one of the features of enterprise value is that it is relatively immune (though not completely so) from purely financial transactions.

“A stock buyback funded with debt, a dividend paid for from an existing cash balance or a debt repayment from cash should leave enterprise value unchanged, unless the resulting shift in capital structure changes the cost of capital for operating assets, which, in turn, can change the estimated value of these assets,” he wrote.

There are complications in trying to arrive at the different values. For market value of equity, besides ordinary shares, there are non-traded shares, management options and convertible securities.

For debts, there are non-traded debts and off-balance sheet debts. For cash, there is a difference between operating and non-operating cash.

Valuing equity, firm or enterprise

What’s the value of an asset? Well, the value of an asset should always be about the cash flow it is able to generate over its life. So if you are valuing equity portion, then you should just take the cash flow available to equity holders only, after deducting interest paid to debt providers, for example.

And you have to discount that cash flow using cost of equity.

If you are valuing the firm, then you take the cash flow generated by the firm’s operations before paying for the cost of capital. You discount the cash flow using the weighted average cost of capital. From there, to get the value of equity, you deduct from the firm value the firm’s outstanding debts.

Recently, I was trying to apply these concepts to a real estate investment.

Say a seller is willing to let go of an apartment at $1.45 million. You can finance that investment with a 60 per cent loan, that is $870,000. You have secured a fixed rate loan from Maybank at 1.15 per cent for the first year, 1.35 per cent and 1.45 per cent for the second and third year, respectively. After the third year, let’s assume that the rate goes up to 3.5 per cent for the remaining 25 years.

Say, you can lease out the apartment for $4,300 in the next two years, and the maintenance is $400 per month.

How should you value this apartment?

So, if you are valuing the apartment as a whole, then you take the cash flow from that apartment and net off all the expenses associated with it. That would include the maintenance, your property tax and your rental income tax. The final cash flow for each of the year going forward is then discounted using your weighted average cost of capital. The cost of debt will be your mortgage rate.

If you are valuing the equity portion of the apartment, then your cash flow will be net of the interest paid on your mortgage.

Here are some of the difficulties I encounter in trying to work out the value of the real estate. One, what is one’s cost of equity when investing in real estate? Two, what will be the cost of debt after the third year? Three, what will be the rental after the second year?

These are some of the usual issues that analysts grapple with when doing valuation for a stock. For stocks, there are certain benchmarks people can peg the cost of equity to. I’m not sure how one should arrive at the cost of equity for personal real-estate holdings.

In any case, I made some assumptions so as to proceed with my exercise. I assume that after two years, the rental will fall to $3,800 and then to $3,500. And from there, it will track the inflation of about 2 per cent a year.

I assume a $6,000 expense annually associated with the apartment. And I assume that the mortgage rate will jump to 3.5 per cent from year four, and stay there.

Finally, I put the cost of equity at 6 per cent. Based on these assumptions, what kind of value did I get for the apartment? Well, the number which I came up with is about $1.36 million.

But tweaking the numbers a little – especially those that have to do with the discount rates such s the mortgage rate or the cost of equity – can cause the valuation to change significantly.

For example, if I assume a mortgage rate of 3 per cent instead of 3.5 per cent from year four onwards, the valuation of the apartment goes up to $1.5 million. A mortgage rate of 4 per cent will reduce the valuation to $1.25 million. If I reduce my cost of equity to 5 per cent, on mortgage rate of 4 per cent, then the valuation is $1.47 million.

Ultimately, such an exercise will allow one to gauge the price levels under various assumptions. From there, one can stress-test one’s comfort level even in the most severe of assumptions. For example, based on the still relatively benign 3.5 per cent mortgage rate by year four, the monthly rental of $3,500 will not be enough to cover the monthly mortgage payment. Will one still be fine with that?

As Prof Damodaran puts it, going through the motion of ascertaining value of an asset based on its estimated cash flow will give one some sort of moorings. Obviously, conditions and assumptions change over time. What we can do is to make estimates based on the best of our knowledge, and constantly be cognizant of our biases.