The Will Robinson Moment continued Part 3

We now move to the balance sheet

5. Balance sheets matter but do not get enough focus in the media as compared to earnings and stock prices. When balance sheets are combined with the earning and price discussion there is often found very important indicators. One of those indicators is the relationship of earnings before deductions for interest costs, taxes and non-cash charges such as depreciation (”EBITDA”), to the overall Enterprise Value (“EV”). EV/EBITDA is a capacity measurement that is computed by dividing the Enterprise Value (“EV”) of a company (its current stock price multiplied by the number of shares outstanding plus the level of debt the company has on its balance sheet, less the amount of cash the company has that offsets the debt owed), divided by the cash flow power of the company as measured by EBITDA. This calculation creates a view of how well the company can support its net debt burden from cash flows, and gives a relative measure of each company’s degree of access to greater capital needed for growth. A low EV/EBITDA number indicates financial strength as the cash flow is high relative to the level of net debt and the current stock price. A high EV/EBITDA is a cause for caution and should be a trigger for greater analysis of the company and the industry characteristics in which it operates. Creating an historic perspective of this indicator over time as prices change, debt and cash levels change, and business prospects change, provides a key element of overall market valuation levels, particularly when combined with the other observations that have been previously discussed elsewhere in this document. With this as a backdrop, what does the EV/EBITDA metric indicate in today’s market? Of concern is the fact that this metric is at its highest level in the past ten years. The EV/EBITDA ratio is 15.03. To provide some comparative data, consider that the low was set in November 2008 after the Lehman bankruptcy filing when the market value decline caused the ratio to fall to 6.64. Over the past ten years prior to 2016, the average high and low ratio was 12.31 and 9.21, respectively. The current level of 15.03X is a cause of concern, but the driver of this needs to be better understood. If balance sheets are relatively stable in terms of the cash to debt levels, and the high multiple of the EV/EBITDA is driven by a decline in earnings, then the determinant of level of concern would be prospects for higher operating performance in the future to support the market value component of EV. If, however, the debt and cash levels have changed in a way where the companies reveal high EV/EBITDA multiples because debt meaningfully exceeds cash in a way that poses risks to the funding of future growth, then a concern for the high market value of the stocks must be taken into account in assessing prospects for future price increases and the potential risk of a material price decline. This is where a meaningful problem or issue exists in the 2016 analysis. Debt has grown since 2013 by 39% while cash on the balance sheet has only grown by 13% (for the 187 company portfolio, debt has increased in dollar terms by $475 billion whereas cash balances have only increased by $105 billion). Further, cash flow growth over this period has grown by only 16% while prices have risen by 31.5%. So, the balance sheet deterioration in terms of higher leverage and the slowing in earning/cash flow growth are real problems in the current market state. Couple this with the lack of robust projected growth in earnings and cash flow at a time when the balance sheet starting point is weakened creates a very high concern for maintaining the current level of stock prices in the market.

6. The balance sheet discussion and capacity to source additional capital for growth also offers the opportunity to talk to the cost of financing and what if anything we may learn from looking at changes in the cost of capital. The Weighted Average Cost of Capital (“WACC”) is currently at the lowest level in the past ten years. The key driver of the decline in the WACC is the equity component. WACC is a blend of the cost of debt (interest rates) and the cost of issuing shares (required return sought by investors to own shares of stock) weighted based on the proportion of debt to equity levels. Interest rates have been very low since the financial crisis of 2008, so the past eight years have encouraged debt growth as a low-cost source of capital. With the recent rise in interest rates, that low cost source of capital may begin to become more limited. The cost of equity is very much influenced by the perceived risk that investors in equities believe is inherent in owning stock. This equity risk is a price risk as well as a return on investment risk in the form of dividends and dividend growth prospects. When the market is relatively calm, upward trending, and backstopped in the minds of investors by external influencers such as the Federal Reserve or other governmental bodies, then the appetite of investors to pursue equities is large and their demand for high compensation is lowered as they perceive less risk exists. It is in these calm or perceived calm waters that we see aggressive buying of stock with an almost risk-free attitude. Given the world in which we make investment decisions, and the manner in which that world is changing, the question of whether we have more, less or the same uncertainties to consider must be addressed. Presently, the equity component of the WACC has a cost that is below 10%. This is a very low rate of required return. In fact, history would indicate that a rate of 13% or more is a better reflection of the historical cost needed to compensate equity holders for the uncertainty in holding equity vs debt. Given the political and global economic risks that exist in the world today, it must be asked whether the current equity market pricing and demands by investors are reflecting complacency and in doing so are ignoring/mispricing the realities of the risks present in the world? This is a subjective question to some extent, and investor fear or decisions to de-risk often are quick to change in a world where events occur with little forewarning. Pricing the cost of equity capital at a level below 10% in a rising interest rate environment and in the face of a new governmental leader for the United States, coupled with BREXIT, movement in the price of oil, European concerns, and actions by China and Russia, all of which add to uncertainty that arguably is NOT being reflected in the pricing of the equity market should give one reason to pause. Given the speed with which equity investors may pull back from the market should uncertainty be felt as increasing, it may require great caution and vigilance to ensure return of capital is seen as the more important goal then return on capital in the present market place.

More to come……………….

Author: Thomas Connolly

Tom possesses a rich and diverse background that includes deep investing experience, senior corporate executive positions, and roles as a Regional Managing Partner and Global Industry Leader within Ernst & Young. He has advised executives on some of the largest acquisitions and dispositions in the Media and Entertainment industry, including clients such as Comcast, Citibank, Sony, Dalian Wanda and Publicis. Tom is a Certified Public Accountant with a Masters Degree from Columbia University. His skills are further accompanied by a personal passion for the study of economic trends and evolving market dynamics.

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