Fructivore Investments

I had a surprisingly bad experience at a certain investing website that accepts user submissions and I thought I would speak of it. Last week I spoke highly of BorgWarner and thought a wider audience might benefit from my views, so I submitted my last post to them.

I proposed that the equity was worth $4.8 billion, plus $2.1 billion in the company’s excess cash, plus about $400 million in the present value of the company’s below market interest rate, total $7.3 billion. My editors, including two managing editors, though, argued that if I wanted to add the company’s excess cash to the equity, I would have to remove the company’s long term debt from it as well. Naturally, I found this quite confusing because I thought I already deducted it from the assets to arrive at the equity in the first place, and that under their rules the company was worth less money with the excess cash than without it, but they weren’t having it.

Now, the formula for Enterprise Value is EV = Equity + debt – cash. This equation is so ubiquitous that I can’t really think of a citation for it, so let’s just say The CFA Curriculum (any level), vol. 2. The equation can easily be rewritten as Equity = EV – debt + cash. Now, the equation that the editors are using, equity = EV – debt + cash – debt, I am quite unable to find a citation for.

I think it was the “- cash” part that was throwing them off, because I am a firm believer in the concept of excess cash, of which BorgWarner has $2.1 billion based on the usual formula. And for the sake of avoiding double counting, I scrupulously removed any of the interest on the excess cash, so that $4.8 billion is what the equity of BorgWarner would be worth if the company had no cash at all.

We may check the math as follows: Enterprise value is also the free cash flow to firm discounted at the weighted average cost of capital. The weighted average cost of capital is the long term debt weight of 5.7% * 3.7 billion, plus 12.5% * 4.8 billion/8.5 billion, or just about 9.5%, and $811 million per year capitalized at 9.5% is $8.5 billion again (unsurprising since I’m just reversing the weighted average cost of capital formula). The value of the equity is based on a discount of the free cash flow to the equity at 12.5% and matches the one computed from the enterprise value equation (as it should since I supplied the numbers myself), and now the cash must be dealt with somehow. In fact, the enterprise value equation does not distinguish between excess and non-excess cash so the raw equation is even more generous to my point of view.

And here, again, is where my editors insist for whatever reason that I subtract the debt again, which, in addition to being based on the equation conjured from their own fevered brains, also messes up the enterprise value based on weighted average cost of capital as it essentially assumes that the company will pay off its long term debt and yet continue to pay interest on that debt for some reason.

In fairness, a company cannot operate with no cash at all, and even though BorgWarner is cash flow positive and has an untapped $2 billion line of credit it may find it useful to keep some cash on hand. A rule of thumb is 2% of annual sales, which in BorgWarner’s case works out to $280 million, but the company could give up at least the $1.8 billion in cash left over. And obviously a company can have excess debt, current or long-term, and any cash used to pay that down would be unavailable to the shareholders, but BorgWarner is not such a company and therefore there is no reason to assume that its long-term debt will be paid off at any point in the foreseeable future.

I was trying to explain my reasoning, although perhaps not as well as I might because I was still stunned into inarticulacy that they were using the special EV = equity + 2*debt – cash formula that their editorial policy has apparently forced on them, when they declared their decision was final. Suffice to say, I will not be renewing my trial membership.

Filed under:
Investing by grocca