When two companies have wildly different capital structures, you have to compare them on enterprise value, not the market cap of their equity. So while I give kudos to Tesla for building a valuable business, it still has a long way to go to catch up to Ford.
> When two companies have wildly different capital structures, you have to compare them on enterprise value, not the market cap of their equity. So while I give kudos to Tesla for building a valuable business, it still has a long way to go to catch up to Ford.
That is not necessarily true.
Market cap and enterprise value are two equally valid ways of measuring value or worth. There are even more ways to measure value, such as DCF or value of assets. All of these have their pros and cons.
In this case, my personal opinion is that market cap is a very meaningful way to measure Tesla/Ford and that it's noteworthy that Tesla has passed Ford.
I think it is very meaningful because it (loosely) implies that the present value of Tesla's profits (i.e. net profit after tax) is higher than Ford's. Even on a risk-weighted basis. Or, at least, that's roughly-kinda-sorta what the market believes.
I would argue that enterprise value would be more meaningful that market cap if we were talking about which company was 'bigger'. However, the interesting thing here is that Tesla has become more 'valuable' than Ford, for this definition of value.
With Tesla, there's an obvious path for potential massive growth. It's not guaranteed, but the potential is obvious.
With Ford, it's like any other auto manufacturer. What surprises are we expecting? What new products or innovations? Does Ford have any path, even hypothetical, to massive market share growth relative to its current position the way Tesla does? It seems clear to me that the answer is no. Even if their Bolt is a success, they're not about to dominate the market, double their sales, and double their stock. They don't have any Model 3 type event on the horizon.
So all these comparisons of financial metrics on current value, to me, seem pointless. This is the only thing that should matter (along with whatever analysis you want to use to gauge whether Tesla is likely to be able to execute on its plans, which is a more complex question-- but performance so far makes it clear that they are experiencing steady and dependable growth of production and sales with clear, well-defined plans for further future growth.)
The question isn't necessarily "can this company grow?", it's "what is the value of this enterprise as a cash-generating vehicle?"
That is the basic idea behind value investing and what made Warren Buffett the 2nd wealthiest person in the world.
2: Equity Value therefore represents the market's perspective of the Net Present Value of the future cash flows less the value of the debt. Those flows, calculated using a discounted cash flow spreadsheet, could be from profits, or could be from sale of assets.
3: The analysts will forecast the Enterprise delivering a certain IRR - annualised percentage return, which is split between the debt and equity. This total return is called the weighted average cost of capital - WACC.
4: Debt is cheaper than equity, and it also has a lovely tax shield effect from the interest expense.* Debt holders get the company when the value falls underneath the total value of the debt though, so you don't want to issue too much.
5: Equity (shareholders) demand much higher returns than banks, but accept the greater risk for it. e.g. VCs have much higher expectations than banks about their returns.
6: The more debt you have the higher the returns - and risk - for the equity. Think about the leverage you can get on a house - an asset with low % returns can deliver high value (or high loss) by using a lot of bank debt.
7: There is a body of work around finding the optimum level of equity and debt for a company - basically you want to balance the risk from having too high debt (and the company value falling underneath that value and using all the equity) and the benefits of higher returns to equity=holders from having higher debt.
Going back the the original post - EV is the real value of the company, not market cap. Ford could sell down their debt by issuing more equity, Tesla could issue debt and reduce the share of equity. It all comes back to EV.
*This makes the weighted average cost of capital vary slightly as the amount of debt changes.
EV is one way of valuing a company. As is market cap.
> Ford could sell down their debt by issuing more equity
Absolutely. It's logical to say that a company with less debt is worth more than a company with debt. And the same applies in reverse.
Other ways that EV can be distorted, and market cap can be preferred, is whether the company choose to purchase capital assets financed via debt or lease them. For example, a company with big capital assets financed via debt could note that the company would be more profitable if they sold them and leased them back. The company is now more profitable, and its reasonable to say its 'better', but its EV has gone down.
The "market" (albeit a more limited one) also believes that Uber is worth $70B - almost 1.5X the market cap of Tesla.
How meaningful is that?
I think it's a very tortured definition of "value", though... I don't have a Bloomberg terminal in front of me anymore to check, but I'm guessing Ford's bonds are generally trading closer to par than zero. In which case the bondholders are telling you they think there is about $100 billion worth of additional value to Ford's business beyond the value of the equity. That's a really big piece of context to this story.
I agree with you in principle that market cap is a perfectly valid metric, but when you're comparing a majority-equity company to a majority-debt company (assuming the bonds are valued as non-distressed assets) it ignores something very, very significant.
Enterprise value is the value of the business (the thing actually generating value) separate from the cash & debt it's holding.
For example, if I have a banana stand worth $250K, but inside the banana stand is a briefcase with $245K, then the $250K is not really the value of the banana stand - it's mostly the value of the cash inside. The Enterprise value of the banana stand is only $5K.
With the debt, the idea is the same but the sign is opposite. So if Ford is worth $50B while holding onto $100B of debt, that implies that the enterprise value is $150B.
Comparing the valuations of Ford and Tesla without subtracting out cash and debt is like running a race without mentioning that the losing racer started a half mile behind. Though they 'lost' by one metric, they're still the faster runner.
Obviously both are worth the same amount: each company has an "enterprise value" (the value that all investors in all securities place on the underlying enterprise) of $1,000,000. The only difference is that company A has only one class of investor, while company B has investors that own a riskier asset (the equity) and a less risky asset (the debt). But assuming the two companies are otherwise identical, an investor in company B can easily financially engineer themselves into a financial position that is identical to an investor in company A: for every dollar of company B equity they buy, they simply buy one dollar of company B debt. Owning $1 of company B equity and $1 of company B debt is identical to owning $2 of company A equity.
Since the choice of equity or debt financing is (theoretically) arbitrary, when comparing two companies that have very different capital structures, like Ford (mostly debt-financed) and Tesla (mostly equity-financed) you have to control for those differences. The simplest way is the add the value of each company's net debt to the market value of their equity, which gives you the total market value of each underlying enterprise.
A simple example we're all familiar with is home prices. Two neighbors might own nearly identical houses on the same block in the same town. One might have a mortgage and one might own it outright. But no matter the financial situation of the individual owners, the value of the two houses should be about the same: the value of the asset is separate from the financing of the asset.
There's an important issue that you aren't taking into consideration. The value of the equity is ultimately based on the profit that remains after interest/debt has been paid.
In your example, it is perfectly valid (if not MORE valid) to say that Company A is worth more than Company B.
The investors in Company B figured that at the end of the day they will only be eligible for half the cash that investors in Company A will be eligible for. So they paid a lower price.
You're insisting that debt is another form of investment, and depending on what you're looking at that makes sense, but when talking about 'value' it doesn't always hold true.
This sort of intuition is seductive, because we're generally told "debt bad, equity good!" But it's not correct, for the very simple reason that debt and equity are, in many ways, fungible: each type of financing can be utilized to replace the other.
To go back to the company A & B example: Company A could decide tomorrow to borrow $500,000 and buy back $500,000 worth of stock. Company B could issue $500,000 worth of stock and pay down its debt. Then, just by shuffling some papers around, the capital structures of the two companies will have been reversed! Yet nothing in the underlying business will have changed for either of them.
But don't just take my word for it! Franco Modigliani won a Nobel Prize for his part in the Modigliani-Miller theorem, sometimes called the "capital structure irrelevance principle" (seriously): https://en.wikipedia.org/wiki/Modigliani–Miller_theorem
It's certainly a complicated subject, but debt is very much a real part of a company's capital structure and can't be ignored when comparing two different companies.
Debt can be viewed in many ways. I'm not saying that it's wrong to view debt as another form of financing - like you I studied Modigliani-Miller, just that there are other ways to view it.
My point is only that it's not right to disregard market cap entirely in preference to EV. EV is generally a "more comprehensive" measure of company value, but it doesn't supersede market cap.
EV, for example, is susceptible to distortion between leasing and buying capital assets. For example, a company with big capital assets financed via debt could note that the company would be more profitable if they sold them and leased them back. The company is now more profitable, and its reasonable to say its 'better', but its EV has gone down.
Yes, this is an excellent point. The next-level thing to do when modeling companies that make extensive use of operating leases for capital assets is to capitalize those operating leases, for exactly this reason.
I'm not sure what you mean by this - can you clarify?
> A company that raises money via loans typically has more obligations than one that raises money via equity. Doesn't the option value for repayment count for anything?
Certainly the equity of a highly indebted company will behave differently than the equity of a debt-free company. But "different" isn't necessarily "better". To go back to my company A & B example, if both companies double in enterprise value, the equity holders of company A will get a return of 100% ($1,000,000 profit on capital of $1,000,000), but the equity holders of company B will get a return of 200% ($1,000,000 profit on capital of $500,000). Conversely in a scenario where each company loses half of its value, the equity holders of company A will still be left with half of their money, while the equity holders of company B will be wiped out (to first order - reality is more complicated than this usually).
So in some scenarios the company A equity looks better and in some scenarios the company B equity looks better. Which you prefer overall depends on your individual risk preferences - some people want a higher potential return at the cost of higher risk, some people want less risk at the cost of a lower potential return. There's no objectively "best" structure.
Even for companies with no debt at all you'll see investors who artificially create financial leverage by buying options on the company's equity. Different strokes for different folks, or as my dad likes to say, there's an a$$ for every seat. :)
So I'm wondering how enterprise value prices risk compared to market value.
Consensus on the price of risk, yes. Consensus on risk preferences, no. :) I.e. two people can agree that a one year US Treasury Bill paying 0.50% interest is worth exactly par, and yet come to completely different conclusions about whether they want to own it at that price.
I.e. you're absolutely right about achieving a consensus on how to value an asset, but people's differing risk preferences are a major reason we have markets in the first place - it's not just zero-sum wagering on what will go up and what will go down.
> So I'm wondering how enterprise value prices risk compared to market value.
To the extent a company has debt, the risk (and expected return) of its equity will always be higher than the risk (and expected return) of an identical company without debt: the equity holders have levered up by borrowing and magnified their risk and potential return. I don't know if that answers your question or not, though.
GM and Ford have 200k+ employees each and so much legacy baggage where-as Tesla, even with Scty, only has around 40k employees.
And they mostly tend to be fanatically hard workers.
Also, I know from experience Ford uses their ability to generate cash and borrow cheaply to give "buyouts" to large chunks of retirees at a time (ie. They offer a lump sum of $1 million dollars today instead of a pension. This almost always works out in the company's favor).