Using Enterprise Value To Compare Companies ....

Courtesy : Forbes 

The enterprise value - or EV for short - is an indicator of how the market attributes value to a firm as a whole. Enterprise value is a term coined by analysts to discuss the aggregate value of a company as an enterprise rather than just focusing on its current market capitalization. It measures how much you need to fork out to buy an entire public company. When sizing up a company, investors get a clearer picture of real value with EV than with market capitalization.

Why doesn't market capitalization properly represent a firm's value? It leaves a lot of important factors out, such as a company's debt on the one hand and its cash reserves on the other. Enterprise value is basically a modification of market cap, as it incorporates debt and cash for determining a company's valuation.

The Calculation

Simply put, EV is the sum of a company's market cap and its net debt. To compute the EV, first calculate the company's market cap, add total debt (including long- and short-term debt reported in the balance sheet) and subtract cash and investments (also reported in the balance sheet).

Market capitalization is the share price multiplied by the number of outstanding shares. So, if a company has 10 shares and each currently sells for $25, the market capitalization is $250. This number tells you what you would have to pay to buy every share of the company. Therefore, rather than telling you the company's value, market cap simply represents the company's price tag.

The Role of Debt and Cash

Why are debt and cash considered when valuing a firm? If the firm is sold to a new owner, the buyer has to pay the equity value (in acquisitions, price is typically set higher than the market price) and must also repay the firm's debts. Of course, the buyer gets to keep the cash available with the firm, which is why cash needs to be deducted from the firm's price as represented by market cap.

Think of two companies that have equal market caps. One has no debt on its balance sheet while the other one is debt heavy. The debt-laden company will be making interest payments on the debt over the years. (Preferred stock and convertibles that pay interest should also be considered debt for the purposes of calculating value.) So, even though the two companies have equal market caps, the company with debt is worth more.

By the same token, imagine two companies with equal market caps of $250 and no debt. One has negligible cash and cash equivalents on hand, and the other has $250 in cash. If you bought the first company for $250, you will have a company worth, presumably, $250. But if you bought the second company for $500, it would have cost you just $250, since you instantly get $250 in cash.

If a company with a market cap of $250 carries $150 as long-term debt, an acquirer would ultimately pay a lot more than $250 if he or she were to buy the company's entire stock. The buyer has to assume $150 in debt, which brings the total acquisition price to $400. Long-term debt serves effectively to increase the value of a company, making any assessments that take only the stock into account preliminary at best.

Cash and short-term investments, by contrast, have the opposite effect. They decrease the effective price an acquirer has to pay. Let's say a company with a market cap of $25 has $5 cash in the bank. Although an acquirer would still need to fork out $25 to get the equity, it would immediately recoup $5 from the cash reserve, making the effective price only $20.

Ratio Matters

Frankly, knowing a company's EV alone is not all that useful. You can learn more about a company by comparing EV to a measure of the company's cash flow or EBIT. Comparative ratios demonstrate nicely how EV works better than market cap for assessing companies with differing debt or cash levels or, in other words, differing capital structures.

It is important to use EBIT - earnings before interest and tax - in the comparative ratio because EV assumes that, upon the acquisition of a company, its acquirer immediately pays debt and consumes cash, not accounting for interest costs or interest income. Even better is free cash flow, which helps avoid other accounting distortions.

The Bottom Line

The value of EV lies in its ability to compare companies with different capital structures. By using enterprise value instead of market capitalization to look at the value of a company, investors get a more accurate sense of whether or not a company is truly undervalued.

Concentrated Vs. Diversified Portfolios: Comparing the Pros and Cons.....

Courtesy: Investopedia

Most basic articles on investing advise having a diversified investment portfolio. Diversifying investments is touted as reducing both risk and volatility. However, while a diversified portfolio may indeed reduce your overall level of risk, it may also correspondingly reduce your potential level of capital gains reward. The more extensively diversified an investment portfolio, the greater the likelihood it, at best, mirrors the performance of the overall market. Since many investors aim for better than market average investment returns, they may wish to revisit the issue of diversification versus concentration in their portfolio choices.

Ways to Diversify a Portfolio

There are a number of ways to attain some level of diversification. One is simply company diversification, which is owning stock in more than one company. A portfolio can also be industry diversified. Owning stock in both a banking company and an insurance company is more diversified than simply owning two bank stocks. Further diversification can be achieved by investing in more than one market sector. Another means of diversification is to own stocks of companies with different levels of market capitalization, from small- to large-cap stocks. Portfolio diversification can also be achieved by investing globally rather than just in domestic stocks. Investing in different asset classes, such as stocks, bonds and futures, also creates diversification. Finally, investing choices based on varying trading strategies, such as growth investing and value investing, also provide diversification.

The real question for investors is to what extent they should diversify their investment portfolios, and the answer is that each individual investor should largely be driven by his personal investment goals, level of risk tolerance and choice of investment strategies. Investors should consider the relative advantages and disadvantages of diversification within that personalized investment framework.

Advantages of a Diversified Portfolio

Diversification reduces an investor's overall level of volatility and potential risk. When investments in one industry, market sector or asset class perform poorly, other investments in the portfolio with a negative correlation to the poorly performing investments should perform relatively better and at least partially offset losses and reduce the portfolio's overall volatility. Diversification may also open up additional profit opportunities. For example, an investor who chooses to diversify his portfolio with investments in foreign stocks may find he has invested in the stocks of countries experiencing economic booms, and those stocks produce large gains at a time when the performance of domestic stocks is mediocre to poor.

Disadvantages of Increasing Diversification

The disadvantages of diversification are less publicized, and therefore less well known, but the fact is diversification can also have adverse effects on an investment portfolio. Overly diversifying an investment portfolio tends to reduce potential gains and produce only, at best, average results. If your investment portfolio contains five stocks that are performing wonderfully, but 45 others that are not doing well, those stocks may substantially water down the gains realized from your best stock selections.

Another problem with aiming for broad diversity is it may require extra transaction costs to re-balance your portfolio to maintain that level of diversification. A widely diversified portfolio with a lot of different holdings is generally more trouble to monitor and adjust since the investor has to stay on top of so many different investments. Diversification can even increase risk if diversifying leads an investor to invest in companies or asset classes that he knows little or nothing about but have been added to a portfolio solely for the purpose of achieving diversification.

Advantages of Concentrated Portfolios

One of the advantages of a more concentrated portfolio is that while it does increase risk, it also increases potential reward. Investment portfolios that obtain the highest returns for investors are not typically widely diversified portfolios but those with investments concentrated in a few industries, market sectors or asset classes that are substantially outperforming the overall market. A more concentrated portfolio also enables investors to focus on a manageable number of quality investments.

The Bottom Line

The best path for an investor may be to aim for only a modest amount of diversity while putting his primary focus, not on diversification, but on selecting high-quality investments chosen in accord with his preferred investment strategy of growth investing, income investing or value investing; his personal risk tolerance level; and his overall investment goals. While some level of diversification should be a consideration in constructing an investment portfolio, it should not be the driving concern. The primary focus of an investment portfolio should always be on putting together a portfolio designed to best meet the personal investment goals and financial needs of the individual investor.

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