Misunderstanding Enterprise Value: The Economist & Financial Times Edition

Posted on 06/06/2011

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From the Lex column (“Renault: carmaker is running on empty“) in the Financial Times on 31st May 2011:

Subtract the market value of Renault’s stakes in Nissan, Avtovaz of Russia, Daimler and Volvo, and the stub value of the French carmaker is negative: minus €15 a share.

From the Economist (“Renault’s woes“) on 4th June 2011:

Renault’s market capitalisation is currently €11.7bn (US$16.8bn).  Nissan’s is ¥3.7tn ($45.3bn).  Renault’s stake in Nissan, at $19bn, is worth more on paper than Renault itself.

Both of these publications – and particularly the FT – are implying that because Renault’s stake in Nissan is worth more than Renault’s own market capitalisation, that this means the market assumes a negative value for the remainder of Renault.  They assume that if Renault was to sell off its stakes in Nissan and other major automakers, the proceeds available for distribution to shareholders would exceed the current market capitalisation of the company and shareholders would therefore get an easy win.  This is clearly incorrect, as both publications fail to take into account the liabilities on Renault’s balance sheet.

Owning a share of a company does not confer ownership, but instead a right to the residual cash flows once all liabilities have been satisfied.  This is why analysts also look at enterprise value (which is equal to market capitalisation plus net debt) in order to help them value a business, rather than market capitalisation alone.  In the case of Renault, the company has liabilities of  €47bn, so any sale of the stake in Nissan would secondly have to be used to reduce this indebtedness, unless the bank lenders decided otherwise (note: the first call for a share of the proceeds is likely to come from the tax man for any capital gains tax due).  Shareholders wouldn’t necessarily receive a penny, and they would lose the right to benefit from any further appreciation in the value of the stake.  Also, distributing assets to shareholders while leaving behind too few assets to service liabilities might be viewed as malfeasance by the lenders and could lead to the directors facing criminal charges.

Renault may indeed be trading at a cheap valuation, but we’ll never find-out for sure unless the analysis incorporates the company’s liabilities.  By ignoring Renault’s liabilities, the FT and The Economist are letting their readers down.

The lesson: don’t look at share prices, valuation ratios and other measures in isolation from the liabilities on the balance sheet.

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