Terms Beginning With 'e'

Enterprise value

  • November 02, 2020
  • Team Kalkine

What is enterprise value?

Enterprise value is an important concept in corporate finance. It is a measure of a company’s value based on market capitalisaion, debt, and cash. Therefore, enterprise value includes ownership interest and asset claims from debt, excluding cash. 

Enterprise value essentially represents the cost of buying a business before considering any premium on the acquisition. For an operating and profitable business, the value of the enterprise is equal to the value of its productive operations.

The value of productive operations must represent the value of all net claims against the company’s assets, which are being applied to produce cash for the shareholders, claimants, or stakeholders. 

Market Value: Full diluted shares outstanding is multiplied with the current stock price to calculate the market value of the company. Apart from basic shares outstanding, fully diluted shares include convertible securities, warrants, employee stock options etc.   

Debt: Debt is a source of financing for a company that is favoured by the management since taking on debt does not dilute the ownership of equity shareholders. However, debt holders of the company are preferred over equity shareholders. 

Moreover, debt holders have a claim on the company’s assets before equity shareholders and are paid before the equity shareholders. 

Cash: Cash is the money with the company sitting idle on the balance sheet. But cash is not a static figure and continues to fluctuate consistent with cash needs of the business. 

In case when cash is not used to fund operation, it can be used to pay off debtholders or suppliers. Cash is subtracted from the market value when calculating enterprise value. 

Minority interest: Minority interest is the ownership interest of less than 50% in a company. It represents holding in stock by other company than the parent company. 

Since minority interest represents partial ownership of others in an enterprise, it is kind of an obligation and is added to arrive at the enterprise value. 

Preferred equity: Although the name suggests equity, it is much like debt. Preferred shareholders are ranked above common equity shareholders of the company and ranked below the debtholders of the company. 

In most cases, preferred equity is converted to common equity shares. However, preferred shareholders receive interest before the common equity shareholders because they are ranked above common equity shareholders in the capital structure. 

Since preferred equity is a type of debt until converted to common equity shares, it is added to the market value of the company to get enterprise value. 

Use of enterprise value

Enterprise value is used as a valuation metric for the valuation of companies. It can be used regardless of the company or industry. It is often used in multiples like EV/EBITDA, EV/FCF, or EV/Sales. Enterprise value is also one of the go-to metrics in merger and acquisition valuations. 

Enterprise value includes the debt of the company and is useful for comparing companies with distinct capital structures. Since it covers the equity and debt of the company, it is a kind of holistic metric. 

EV/EBITDA ratio is used extensively in the valuation of companies, especially for mergers and acquisitions. For growing companies and new-age sectors, EV/EBITDA is a better method of valuation compared to the P/E ratio.

Limitations of enterprise value 

Finding the market value of unlisted companies could be difficult. Shares of unlisted companies are quoted at face value, which ignores the potential premium the market is ready to pay for the business. 

Companies with low free-float market capitalisation could have a volatile market capitalisation since a little change in demand for the shares could result in a large change in the price of a stock, thus market capitalisation or market value. 

Enterprise value also assumes that the cash is effectively used to pay off the debt of the company. This assumption may not be true since companies are required to fund daily business operations through cash or debt. It does not consider debt servicing costs. 

Free cash flow vs enterprise value 

Free cash flow of a company is the residual cash left after deducting capital expenditure from operating cash. It basically represents the amount of cash left with the company to honour its obligations like paying off debt or paying dividends. 

Enterprise value is the value of the company. It could change as the market value of the company changes consistently with the changes in the share price. Compared to free cash flow, it represents a takeover value without any premium. 

EBITDA vs Enterprise value 

EBITDA represents earnings of the company during a period of time, which excludes interest, taxes, depreciation and amortisation. It is a metric that shows the earning capability of a firm. Enterprise value, as noted earlier, is a takeover value of firm without any premium. 

Both are completely different metrics in corporate finance. Enterprise value considers debt of the company while EBITDA does not include debt or debt servicing costs/interest payments.

Calculating the cost of a product or an enterprise based on the direct and the indirect costs (overheads) involved. Multiple methods of absorption costing include Direct labour cost percentage rate, Direct material cost percentage rate, Labour hour rate , Prime cost percentage rate and Machine hour rate.    

Darvas Box system Every great trader/investor in the history of the markets had a specific method to approach the markets, which eventually led them to create a good fortune, Darvas Box system is one such method. It is a trend following strategy developed by Nicholas Darvas in the 1950s to identify stocks for good upside potential. This is one of the few methods to trade the markets which uses the combination of both the technical analysis and fundamental analysis for a much more refined decision.  The fundamentals were used to identify the stocks, and technical analysis was used to time the entry and exits. Who was Nicholas Darvas? Nicholas Darvas was arguably one of the greatest stock traders/investors during 1950s – 1960s, but surprisingly he was a ball dancer by profession and not a professional stock trader. Even while trading and building his fortune, he was on a world tour for his performances in many countries and took up trading as a part-time job. In November 1952 he was invited to a Toronto Nightclub for which he received an unusual proposition of getting paid in shares by the club owners. At that time, all he knew was there is something called stocks which moves up and down in value, that’s it. He accepted the offer and received 6k shares of a Canadian mining company Brilund at 60 cents per share, with the condition that if the stock falls below this price within six months, then the owners would make up the difference. This was the introduction of a professional ball dancer to the stock market. Nicholas Darvas couldn’t perform at the club, so he bought those shares as a gesture. Within two months, Brilund touched $1.9, and his initial investment of $3000 turned to $11400, netting in almost three times of his investment. This triggered a curiosity into the stock markets, and he started to explore trading. Origin of the Darvas Box theory Initially, he was trading on his broker’s recommendation, tips from wealthy businessmen, he even approached some advisory services or any source that he could get his hands on for the tips, but all led him to losses. After losing a lot of money, he decided to develop his own theory, and after a lot of trial and error, his observations and continuous refinements he eventually invented his theory “The Box Theory”. So what exactly is the Box Theory? Fundamentals Analysis As stated earlier, the box theory uses a judicious bend of both the technical and fundamentals. Darvas believed that in order to spot a good stock or even a multibagger, there should be something brewing up in the respective sector as a whole or some major fundamental change in that specific company. Generally, the fundamentals that Darvas used to study were on a broader sector level, and not the company-specific fundamentals. Even for the specific company Darvas used to look from a general perspective like, is the company launching a new product which could be a blockbuster hit. He completely refrained from looking at numbers and financial statements as his initial experiment with ratios and financial statements didn’t yield any good result. To know more on the three financial statements read: Income Statement (P&L) Balance Sheet Cash Flow Statement Technical Analysis Darvas was a big believer in price action and volume of the stock. He believed if some major fundamental changes were to take place in a company, this soon shows up in the stock price and its volume of trading as more people get interested in buying or selling the stock. With his observations here realized by just observing the price action, he can participate in the rally which gets triggered by some major fundamental development without actually knowing about the change. Using the box theory, Darvas used to scan stocks based on rising volume as he needed mass participation in the rally. Also, he only picked up those stocks that were already rising. His theory is all about “buy high, sell higher” instead of the conventional belief of “buy low, sell high”. After the stock satisfies both the parameters of increasing price and volume with major underlying fundamental change, Darvas looks to enter the stock. Good read on momentum trading. How and where to enter? Major part of the box theory is based on entry and exit levels. To enter a stock, Darvas looked for a consolidation phase preceded by a rally. A consolidation phase is the price action wherein the price moves up and down in a tight range, that is, a non-directional move. He would then mark the high and low of the consolidation phase with the horizontal line, essentially making it a box-like structure, hence the name “Box Theory”. The high point is called the ceiling, and low is called the floor. Whenever the stocks break above the ceiling, Darvas would look to buy one tick above the ceiling with one tick below floor as a stop-loss point. Pyramiding Darvas discovered early on, in order to become successful in the market your winning bets should yield much more profit than the loss in the losing bets. This led him to do pyramiding in his winning trade, which is clearly defined in the box theory. Pyramiding means to increase the existing position if the stock is going in the favour, which leads to a much higher profit in the winning trades. According to the box theory, the repetition of the entry criterion is the new signal for adding onto the existing position. In other words, after a position, if the stocks stage the same setup, that is, a consolidation after a rally, then the break above the ceiling of this new box would signal to increase position with the revised stop loss of 1 tick below the new floor. In any case, whenever the stock falls below the current floor, the entire position would we sold off at once. This is the only exit condition in the box theory, and there is no method of booking profit upfront as Darvas believed in holding on to a rising stock. The only way to book profit is to let the stock to take out the revised stop loss.

David Ricardo, a renowned economist, is majorly recognised for his theory on wages and profits, theory of international trade, theory of rents and labor theory of value. His economic thinking dominated throughout majority of the 19th century.

Dead Cat Bounce Dead Cat bounce is a colloquial phrase which is quite popular in the financial markets. The term was coined a long time ago and generally referred to the peculiar behaviour of the price. The phrase denotes a recovery in the asset’s price, often a sharp one after a prolonged downtrend. Sometimes it is also referred to a short but sharp fall, succeeded by an equally sharp recovery. How does a downtrend continue for a long time? Quite often, some securities in the financial markets depict a very long downtrend which may last from a few months to a few years depending on the severity of the fundamental headwinds. These prolonged downtrends are so strong that no support levels can withhold the downtrend and the prices keep on falling. Every support level gets taken out by excessive selling, which pushes the prices even lower. These lower prices force the long holders to liquidate their positions as no visible halt in the downtrend is noticed. This liquidation from existing buyers further fuels the selling, leading to the continuation of the downtrend. As the price keeps on falling, the buyers do not get enough confidence to buy and consequently keep getting overpowered by selling pressure continues the downtrend. So what is the ideology behind “Dead Cat Bounce”? In due course of a downtrend, the security tends to become oversold for the time being. Oversold is a technical term is used for security which seems to have fallen quite a bit in a specified period. In other words, a security that has been continually sold in a specified period tends to reach a level wherein the sellers are no more interested in selling at further lower rates. This is where the buyers’ step in and try to buy these stocks at low prices, leading to an increase in demand over the supply. This fresh buying tends to push the price up hence resulting in a short upside movement or, in technical parlance a “Bounce”. This point is where the downtrend witnesses a temporary upside momentum which is exactly quoted as a “Dead Cat Bounce”. The ideology is “Even a dead cat will bounce if fallen from a great height.” Likewise, a short bounce is quite expected after a prolonged downtrend which does not change the trend as a bounce does not mean the cat has become alive. Image Source ©Kalkine Group Does it signify a reversal from a downtrend? A Dead Cat bounce is an upside momentum, witnessed after a prolonged downward trend, generally near the oversold price region. But it is to be noted that this price bounce is merely a reaction of the downtrend which is often witnessed in the oversold areas. This does not change the entire trend, and more often than not, the trend continues in the primary direction after the bounce fizzles out.  Why is it difficult to trade a Dead Cat Bounce? Most of the time it is difficult to trade a move like a Dead Cat Bounce as the bounce is often very quick and short-lived. The overall trend remains negative, which is in contradictory to the short-term bounce. Also, few investors mistake it for the trend change, which often proves to be a mistake.  It generally becomes difficult to estimate some key support areas from where the bounce may occur as the downtrend is quite strong and lacks demand to support the price. However, there are some momentum indicators like RSI (Relative Strength Index), Stochastics oscillator etc. which may help to gauge oversold zones from where the bounce may occur. What are the reasons for a Dead Cat Bounce? There could be many reasons for a Dead Cat Bounce to occur on the charts as the sudden demand may come due to numerous reasons. Some of the reasons are Oversold Price As discussed, due to a prolonged downtrend and continued selling the price often comes to a level wherein the sellers are no more interested in selling at these lower prices and at the same time buyers often find a value proposition. This leads to a spike in demand, which ultimately results in a Dead Cat Bounce. Strong support area There are some levels of support on the price chart that are quite prominent. In other words, there are some regions of support which are quite strong and may remain relevant for years. These support levels are generally hard to break at the first attempt, which results in a bounce or a complete reversal.  How to profit from a Dead Cat Bounce There are two different strategies when it comes to trading these kinds of sharp and against the trend moves. They are contradictory to each other, but both are based on proven price behaviour. Short Selling the rally As the primary trend of the underlying is still downward, one thought arises to go short on the bounce. This strategy one to participate in the downtrend but with a much better price. If these rallies are met with a resistance level like a falling trendline, horizontal price resistance etc. then these areas are ideal to sell the bounce in a downtrend.  Buying into the rally Another opinion arises, why not to participate in the bounce? This strategy can also be fruitful provided the bounce should be stronger and last for a while, which is not always the case. This essentially calls for a very quick decision making while capitalising on the temporary bounce.  Bottomline A Dead Cat Bounce is a prolonged downtrend followed by a short-term bounce. These bounces generally don’t last long, and once they fade, the trend continues towards the south. However, sometimes a bounce may also act as a reversal, but for the added confirmation a trader should also look at other signals of a reversal like bullish divergence at the bottom or a double bottom chart pattern.

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