Skip to main content
Message Font: Serif | Sans-Serif
 
No. of Recommendations: 1
Not sure that I have been helpful but hope springeth eternal.

One thing that hasn't been discussed much is the idea of book value compared to reproduction value. Reproduction value is estimated by its market value. (As a reference, Bruce Greenwald and his Value Investing book has done a good job of discussing this topic with real world examples.)

So:

If ROIC = WACC then book value should approximate reproduction value.
If ROIC < WACC then book value would be greater
If ROIC > WACC then market value would be greater

Now if in AEO's case, the market is assuming that the company is creating value and the operating profits of the company exceed the cost of the assets currently employed by the company (even after capitalizing operating leases). Or in terms of a multiple, to "own" the cash flow generation of AEO, one would have to pay over 2X the book value (which includes the debt equivalent of operating leases).

Consider a third party who wants to enter the apparel business. They can either start their own firm or buy AEO outright. Would someone be able to replicate AEO (and its profitability) with just the book value. I don't think so. Most likely they would have to spend at least @ 3.93B which is the company's current Enterprise Value. Given Hewitt's operating lease calculation of $838 million and the latest 10-Q, I get a very rough cut invested capital of $1.8 billion.

So to make the leap. If I was going to purchase AEO outright I would love to take it for $1.8 billion but the market would not let me and I would most likely have to settle for the current Enterprise Value. Next, I would have to determine how much equity I was going to use and therefore how much debt I was going to need to raise. Thus a target debt to equity ratio -- just like a LBO firm does, needs to be set based on the price I was going to pay to own (or at least partially own with the other sources of financing) the company.

And that target ratio is based on the market value of the firm not the original capital invested in the company that has been used to created the current value in the market place.

Interestingly enough that was one of the big drivers for LBO's were finding firms that they could recapitalize (ie push the debt level up) and profit from the additional leverage the firm was taking on.

Anyway, that's how I see it and why I would use market values to determine WACC.

MrT
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.