Advanced valuation items change PPG’s value dramatically
Valuing a company is a tricky thing to do. At the best of times, the company has simple items that are nicely laid out in its balance sheet, market value is easy and we put them into the EV formula. The simplest version is:
Enterprise Value = Equity + Debt – Cash
But what do we do with items that don’t fit nicely into this formula? Let’s use PPG as an example. If we use their restated figures for 31 December 2017 (and using the share price as of 20 Feb 2019) the formula reads like this:
Enterprise value $29.90bn = equity $27.24bn + debt $4.15bn – cash $1.49bn
We have calculated an implied EV. Great, it feels like we’re 95% there already.
But every item from a company’s balance sheet needs to go into that formula – many will be within EV, but others help us calculate EV. And what about off-balance sheet items? Where would you put (and what figure would you use) for pension liability, pension assets, capital leases, operating leases, provisions, non-controlling interest, equity affiliates/associates, etc? And they are the more common complex items – the list goes on with items specific to the company you are looking at – what about asbestos settlement and restructuring reserves? And many produce even more questions – equity affiliates could be a core OR non-core asset. If it is non-core, where does it go in the formula, and what figure would you use? The book value from the balance sheet?
None of these answers are easy, and once they are included in the enterprise value formula we want to calculate the company’s EV / EBIT ratio. But how will EBIT be affected by the items mentioned above? How are pension expenses included in EBIT currently, and how should they be included?
The questions are many, but each has an answer. To start, let’s go back to the enterprise value formula. We could re-write it as:
Enterprise value = equity + non-operating liabilities – non operating assets
And with that in mind, the complex items slot in like this:
EV = diluted equity + debt + pension deficit + value of leases + provisions + NCI – cash and equivalents – equity affiliates
Each item in the formula needs a market valuation, the explanation for which would fill 50 articles (!), but if we include them all then PPG’s implied EV increases over $3.1bn. EBIT is then adjusted to only include operating expenses and income (remember EV is the implied market value of the company’s operations, so only operating expenses can be included in EBIT). Going back to the pension expense as an example, we only include the pension service cost – the employee has worked 1 more year so gets a bigger pension, but most other pension costs are not operational so must be ignored when calculating EBIT.
This process of valuing the items to go in EV, and cleaning EBIT, is carried out for each complex valuation item. In the table below we show how including these items changes the EV / EBIT ratio.
|EV / EBIT||13.91 x||14.5 x|
We see that neglecting to include these advanced items will have a significant impact on the EV we place on PPG, and the value of any comparable companies too. Make sure your models are correct!