I received the following question from a reader and wanted to share my answer for a couple of reasons: 1) to make sure I’m giving him the right advice, and b) it seems like a very simple question, but it’s actually a little complex. This second point is the reason I started this journal, because it’s rare that things are as they seem in private equity.
The Question: There is a company with 100 outstanding shares and the market price of each share is $10. Now, if the company issues 10 shares through a private placement at price of say $12. Everything else (i.e. debt, cash etc.) remains same. What will happen to Enterprise Value? Will it increase or decrease? Why? How will EV be affected if the private placement is done at discount to current share price (i.e at $8)?
EV is generally used as a proxy for market value. So it really depends if the issue of shares is adding to the market value of the business. At one extreme, if you issue the shares and set fire to the cash you just raised, then EV will stay the same and your individual shares will just be worth less. At the other extreme, if you buy a distressed competitor for $1, and synergies mean you double the value of your business, then EV will roughly double, meaning your shares will increase in price.
So the important distinction is that we tend to work backwards with the EV equation. That is, we work out EV (often using a multiple of cash flow or earnings), then we subtract net debt to find the equity value. This makes it a “market” valuation. We generally don’t add up the book value or par value of shares and add the book value of debt, because that would be a “book” value and not necessarily represent what people will pay in the market.
So, let’s work through some numbers.
- If the equity is issued for no reason, just to increase cash for a rainy day, then there is no affect on enterprise value (EV). Theoretically, equity increases, but so does cash, which offsets debt to give net debt. Intuitively, if you sell the business the day after raising the money, the cash is just used to pay back the people that just funded the new issue. Practically, it could be a little different. If you raised money at a premium, the new shareholders will get less back as the new cash is shared between everyone (either by paying down debt or via a capital return). The opposite happens if you issue at a discount.
- If the equity is issued to invest in the business, then the affect on EV depends on the profitability of the investment. Remember, we’re working with market value. If the “market” values the investment at cost, then it cancels out. If they value the investment at zero, the EV stays the same, the equity value stays the same, but you have more share, so the per share price drops. If they value it above cost, then the opposite happens.
Does this sound right to everyone? Any comments?