Enterprise Value of Company

Hi boarders,
Last few days I was reading a book "The Little Book That Beats the Market" and it explains the use of Magic formula to find undervalued stocks.
Has anybody read this book so far? I tried to find Enterprise Value of a company from rediff to use in this formula. But I have few queries in this regard. Like do we have to consider Reserves & Surplus amount and if yes then do we have to subtract it from market capital?
EV = Market Cap + Debt + Preferred Shares - Cash Equivalent
So Reserves & surplus amount can be considered as Cash Equivalent?
Earnings on Capital = EBIT / EV

Please help me.

Thanks in advance.

Where did you get this formula for EV from? Don't think it's that simplistic.

You can google on EV to get the formula of EV.
EV = Market Cap + Debt + Preferred Shares - Cash Eqv.
You can also find it on wikipedia

EV = Value of Debt + Value of Equity

basically u need to calculate the Free Cash Flow (FCF) from the point of view of both debt and equity holders or the cumulative free cash flow

Its a lengthy exercise and takes a lot of time and patience as u will need to forecast FCF for the next 5-10 years and this requires to build in assumptions like Growth Rate , Cost of Debt , Cost of Equity etc , Constant Def Tax Rate etc etc.

Joel Greenblatt has not explained properly the calculations of EV.

In short EV = PV (Present Value) of all the FCF + PV of Continuing Value

Ill post the calculations and the procedure as time permits . Hopefully this should clear a few doubts.

To begin look at the sales for the past 5 years and keep a copy of the current Balance Sheet for the Financial year. Balance Sheet of the last two Financial Years should be readily available and based on the available data forecast an income statement for the next 5-10 years . After this is done we begin with Free Cash Flows to calculate the Enterprise Value using a Discounting Rate

Assumptions :

1> Growth Rate Constant
2> Def Tax Rate Constant
3> Depreciation Rate Constant

FCF :

1st thing to look at is PAT (Profit After Tax)

then comes Interest Paid

PAT + Interest Paid --Equation 1

After this calculate the def tax and subtract from Equation 1

The net result is NOPAT (Net Operating Profit After Tax) -- Eq 2

Then consider the difference in Depreciation in the Balance Sheet or just directly take the depreciation value from the Income Statement . Also add back Amortization using the difference between two years (Current and Previous Year)

This gives us EBITDA (Earnings before Interest Tax Depreciation Amortization) ---Eq 3

Now u need to calculate the change in Net Working Capital (NWC)

NWC = Current Assets - Current Liabilities
Calculate the change for the last FY and the current one and the add the difference --Eq 4
This should be (negative) as CL > CA under normal circumstances no matter what the economic conditions are .

After this we reach a point where u look at the investments that the company has made in Property , Plant and Equipment (PPE) ---Eq 5
This should also be negative under normal conditions as the company aims at increasing or tries to peg the production/service (whatever the type of operations are)

Calculate the change for the last FY and the current one

So ..Equation 1 + 2 + 3 + 4 + 5

This gives us Free Cash Flow

This is where the tricky part begins. Calculations of Discounting Factor

More on that later

Sorry for the inconvenience

Good post!

Now after calculating FCF we need to Discount these Cash Flows and bring them back in Present Value (PV) . To do so we need to calculate a Discounting Factor better known as Weighted Average Cost Of Capital (WACC)

The following information will be required to calculate WACC

1> Cost Of Equity : Ke
2> Equity (Absolute Value)
3> Cost Of Debt : Kd
4> Debt (Absolute Value)

Using the latest financial Balance sheet note down the amount mentioned in Share Capital and Secured/Unsecured Loans in SOURCE OF FUNDS

Using the latest Profit and Loss Statement note down the amount mentioned in Interest Paid and then divide by the Debt Instrument , this will give you the Kd

Now we need to calculate the Ke
To do so we need to know the following variables

1> Risk Free Rate of Return (T-Bill preferably )
2> Historical Returns of the market from the time the company has issued its IPO i.e it would either be NIFTY returns or BSE Sensex Returns
3> Beta of the Stock

Ill explain the steps involved in calculation of beta and discount the FCF's in the consequent post.

HI Inagnia

Your Post on EV was fantastic .. Please proceed the thread ..

Shankar

Hi Shankar. Unfortunately this thread slipped out of my mind and i forgot to complete what i started. I apologize for that. As time permits i'll post the methods and means through which Ke can be obtained and the importance of CAPM.

Cheers
Happy Trading

Extriminate to answer you I have read this book and i think i do understand a bit of what you are searching(Infact I too was doing the same then). So to calculate EV You do have to add reserves and they are to be considered as cash equivalent of company(the author skipped about reserves).Now if you have read carefully the author clearly explains that the parameter is similar to RONW. Practically for Indian Market if you want to follow the formula use ROCE and P/E in ranking(it's ranking afterall). The main difficulty with this book is

add 10 on both sides and still the results are similar but can you still think it's perfect pick (Answer is No).

The author did skip the timing part. Not to discourage the method but us it as a parameter.The timing is key. For example if you bought TVS Motors @ 100 then you lose 50% right now. if you bought @ 19 it is some 30% up.

Inangia please keep on the good work :clapping:

i always found it difficult to estimate future cash flows please address that issue as well. :clap:. Good to see people valuing fundamentals also