Skip to main content
Message Font: Serif | Sans-Serif
 
No. of Recommendations: 0
Hi Joe...

If I want to buy the whole company today, I have to pay X ... so, therefore, it must be *worth* X. Extrapolate that down to the per share level, and you have momentum investing :) Perhaps one wouldn't buy the company outright at today's price ... because it's overvalued.

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.

So encouraging the company, if you will, to find the sweet spot of equity to debt that returns the greatest value.

This is an interesting conundrum in my opinion. A stable company with zero debt would mathmatically serve shareholders better by taking on some debt and returning the cash to shareholders if it didn't need to put it to use. However, there's a very real benefit, in my remedial opinion, to remaining debt free and having the headroom to weather a downturn, industry trouble, managment misstep, natural disaster, etc. Finding that sweet spot may optimize performance if everything stays the course, but that's rarely case. I think after watching a handful of debt-free companies lever up over the last year or so and then destroy their balance sheets when they hit a bump in the road, I'd prefer the headroom that comes from being debt free to a company in that sweetspot... even though a dcf will favor the opposite.

Oh well, enough rambling from me before I say more things that display how little I know. :(

kevin
Print the post  

Announcements

What was Your Dumbest Investment?
Share it with us -- and learn from others' stories of flubs.
When Life Gives You Lemons
We all have had hardships and made poor decisions. The important thing is how we respond and grow. Read the story of a Fool who started from nothing, and looks to gain everything.
Contact Us
Contact Customer Service and other Fool departments here.
Work for Fools?
Winner of the Washingtonian great places to work, and Glassdoor #1 Company to Work For 2015! Have access to all of TMF's online and email products for FREE, and be paid for your contributions to TMF! Click the link and start your Fool career.