The Motley Fool Discussion Boards

Previous Page

Investing Strategies / It's Earnings That Count


Subject:  Re: Question for Hewitt about WACC Date:  2/24/2008  10:22 PM
Author:  valuemoosie Number:  1436 of 1817


I don't think that's exactly the argument though. Remember... we're only discussing the market "value" for equity as opposed to the book "value" of equity. Your decision between the two only determines the debt/equity split to get the weighting used in cost of capital. Suppose the shares have been bid up to some astronomically high level... the only impact to your valuation by choosing market value of equity will be that cost of debt has effectively no weight in cost of capital. Since equity is more expensive than debt (for any realistically predictable company that a DCF is worthwhile for), an absurdly high market value for equity will actually give you a lower intrinsic value (than using book value for equity) for the company since you'll discount future cash at a higher rate. Assuming your hypothetically overvalued company trades at a p/b >> 1, using market value of equity will give you a lower intrinsic value than using book value, and therefore seems to be the more conservative approach.

I need to think about this a bit, but my initial reaction is moderate epiphany. Woohoo, I get it! This helps quite a bit.

Here's an interesting link re: the debt-to-equity sweet spot for adding most shareholder value:

There's a little chart at the bottom that I found interesting.

I certainly hear you regarding debt on the balance sheet. I look at it a bit differently, though. Your view (albeit I realize it's only part of your view, and you were making a point) makes me think of how I feel about my mortgage. When I'm feeling financially vulnerable for any reason, my knee jerk thought is to pay down / pay off my mortgage. Safe, very safe.

But then I realize that my primary home mortgage, as long as the balance is reasonable to it's value (ahem, subprime, cough), and more importantly, the payments are *easily* within my wallet, then it is one of the few *very* sensible forms of personal debt. Much better than, say, renting for 30 years while saving the cash to buy a house outright when I'm 55 years old.

So, my point is that a company can not only use debt responsibly, it may in fact be irresponsible to ignore the option of using debt as *some* portion of invested capital, as long as the return on that capital is greater than it's cost, and by taking on some debt, that cost is reduced, since as you say, equity is more expensive.

Rambling now...

Copyright 1996-2022 trademark and the "Fool" logo is a trademark of The Motley Fool, Inc. Contact Us