In the years that followed, a phrase I heard once stuck with me: “Boys read Playboy magazines and men read financial reports.” Since then, I’ve learnt a lot about analyzing financial statements, identifying risks and valuing companies.
Fast-forward to 2016, I’ve been involved in building solar cars at university, earned my Masters in Electrical Engineering and with four other founders, we incorporated Lightyear to commercialize extremely efficient (solar) electric cars. My fundamental motivation behind starting Lightyear: only with minimal/no dependence on grid infrastructure will electric cars ever work in Africa — a continent really close to my heart. And at some point they’ll have to work there if we want to eliminate combustion cars. So we started with the technology as soon as we could. At Lightyear, I fulfilled the role of CFO for the first 3,5 years until just recently we welcomed Laurens. I am now able to dive deeper into the true fundamentals of value creation and financing structures. A part of which I would like to share with you...
“Only with minimal/no dependence on grid infrastructure will electric cars ever work in Africa — a continent really close to my heart".
Enterprise value: the basics
To start: a simplification of a fundamental company valuation formula:
Enterprise Value = Equity Value (a.k.a. “Market Cap.”) + Debt Value − Cash
Usually, when the media mentions the “value” of a company, they refer to the Equity Value (or “Market Capitalization”) — which is not the full picture. Market Capitalization is the (trading) price of one share multiplied by the amount of shares outstanding (owned by shareholders). The Enterprise Value of publicly traded companies is easily measurable, but is not directly influenced by the valuables it’s measured by. For example, Tesla Inc. had $15 Billion outstanding in Debt, a $74 Billion Market Capitalization and $6 Billion in cash at the end of 2019. Using the formula above, its Enterprise Value was valued at $83 Billion. At the beginning of September 2020, its Equity Value increased to roughly $450 Billion without a significant move in Debt or Cash, implying a drastic increase in Enterprise Value. Mystery? Well, maybe not.
Expected future earnings: the main enterprise value driver
What drives the Enterprise Value of a company? Informed investors estimate the future earning potential of a company and are willing to pay a price for these future earnings. Likewise, sellers do the same, but are willing to sell if the price buyers are willing to pay is perceived as fair. Thus, historical earnings only serves as calibration of the buying and selling investors’ future estimations/predictions. This is precisely the reason that ‘growth companies’ could have higher Enterprise Values than ‘flat-line’ (thus declining?) behemoths. The true reasoning behind the common warning: "past performance is no guarantee of future results". On this note: when too many investors have it wrong at some point, markets crash or rise dramatically, depending on what that new insight is.
Stock trading: agreeing on the equity value
In an efficient market, those who overestimate future earnings will buy more shares (or invest directly into the company) and those who underestimate will sell their shares (or more dramatically, sell borrowed shares: a.k.a. “short selling”). Hereby, a (share)price is established between buyers and sellers, reflecting the average future earnings expectation. (For further reading, check this Dutch article in which Lex, my co-founder and Lightyear’s CEO, talks about superforecasting).
The Enterprise Value is often estimated using a discounted cash flow analysis where all forecasted free cash flow (tax-adjusted cash generated by the company for all share- and debt holders, i.e. excess cash after profits have been reinvested into the business) is discounted to the present. (For background information on this, please read up on time value of money). The discount rate could be seen as the required growth rate from the perspective of the investor to account for the risks he/she identified for that specific company — the risks that the expected free cash flow may be lower than anticipated.
Comparing enterprise value for declining vs. growing companies
So suppose you identify a company (for simplicity: without Debt and no Cash, so Enterprise Value is Equity Value) with a declining free cash flow earning potential starting high with $100 in the first year and declining by $10 per share for the next 10 years. You require a return of 20% per year to compensate for the risks of this company, then, from your perspective, those earnings are worth only $290 and not $100 + $90 + $80 ... = $550. Possibly the share would be worthless after year 10, because there is no future earnings beyond that point.
Now consider a growth company, where the free cash flow is not declining for the next ten years, but increases by 30% YoY after the first year being a mere $35 and the second year only $45.5, etc. Keeping the required return and thus discount of 20% equal, you’d value the sum of these free cash flows at $430 (even when neglecting the value of the share after year 10). The $430 is almost double the value compared to the $290 above, albeit its earnings starting from a significantly lower point: $35 vs. $100.
Looking forward: The Future is now
Question: which company (or collection of companies) will address the growing Electric Vehicle (EV) market as predicted by Bloomberg? I’ll give you a hint: it’s either going to be incumbents (brands in existence since the eighteen or nineteen hundreds), current well-established EV-only players, new market entrants or those that haven’t even started yet. Easy huh? Nobody knows the future, but try making some predictions for yourself and don’t linger too much on the past. The future is now!
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