defining vmg's ev

[This posting is in response to a question raised by vfrioni on a thread for MCP. It relates to the derivation of Enterprise Value, using VMG as a case study.]

Vfrioni,

(Apologies for taking this long to respond, but I am not really all that good at observing HC protocols in that I only check threads on which I have participated infrequently.)

The defining of a firm's Enterprise Value (EV) for investment purposes is a function of two overarching considerations: a) whether the firm will continue as a going concern, or wound down and "asset stripped", and b) the materiality of the liabilities in the context of the EV

In its purest form, Enterprise Value is the value that would be ascribed to an entity if it was to be acquired and the intention of the acquirer was to settle ALL claims against the business (for whatever odd reasons). This means it would include all the lenders, trade creditors, tax authorities, staff entitlements, refund of prepayments (if any). Importantly, this would include current and non-current obligations.

GOING CONCERN
In practical terms, however, in almost all cases, acquirers of businesses (including people like ourselves who, as investors, acquirer small parts of businesses) invest on the basis that the enterprise is to continue operating as a going concern. This means that some liabilities, while they exist in a clear and tactile sense, can be rolled over ? without any explicit cost - either to subsequent periods, or if the business is believe to continue operating indefinitely, then some liabilities can be assumed to be rolled over to perpetuity, and therefore need not be included in the EV calculation. Examples of these are provisions for restructuring or for staff entitlements, trade creditors, prepayments, and tax liabilities.

Capital market practitioners ? who, by definition invest on the assumption that businesses will continue indefinitely as going concerns ? follow the convention that liabilities only form part of the EV equation if, and when, they have some charge attached to them. For example, debt has a real time cost, while trade creditors and tax liabilites are "free". That is why the definition of EV has evolved to: Market Capitalisation plus Net Interest Bearing Debt.

The reason provisions are excluded from the EV calculation is because in the raising of the provision, this will have had the impact of reducing the EBITDA in the period that the provision was raised. And because in most cases EV is applied as a multiple of EBITDA as a valuation measure, to include provisions in EV would be double counting in the EV/EBITDA ratio.

Trade creditors, in turn are ignored because they are invariably funded - in part at least - by debtors and inventory on the asset side of the balance sheet.

Tax liabilities are excluded for a similar reason to provisions, in that the tax expense that gave rise to the outstanding tax liability has already been reflected in historical financial results, on which the market cap is implicitly derived by the equity market.

MATERIALITY
Then there is the issue of materiality.
In most cases claims against the business such as taxation due, provisions, and creditors, are relatively small compared to a listed company's market capitalisation. However, a company's net debt can often be of the same order of magnitude as it market capitalisation.

Take your example, VMG, as a case in point:

Let's look at the total claims against the business:
Net Interest Bearing Deb = $17.5m (includes current and non-current debt)
Payables = $76.8m
Provisions = $14.7m (non-current) + $0.8m (current)
Tax Liability = $12.0m (current)

So, total Claims against the business = $122m (the bulk of which is made up of Trade Payables), compared against a Market Capitalisation of some $100m.
This yields a "pure" EV of $222m

However, this is not truly representative because the following adjustments can- and soem of them probably should - be made:
? Payables: this really needs to be seen in the context of the other working capital components which, it must be assumed by would-be acquirers of the business, will be liquidated within 12 months to fund settlement of Payables. In VMG's case, Receivables are $55.1m and Inventories are $48.8m. So really, this amounts to a net "credit" to the business (to the tune of $27m), as opposed to a net claim
? Provisions: Of the $14.7m, only $6.5m (a contingent consideration, refer note 23 to the accounts, 2010 Annual Report) is what I would call a current and "real" claim against the business; the balance ($8.2m) relates to staff entitlements, which would mostly be rolled over as the business continued to trade
? Tax Liability: While the gross tax liability is $12m, Note 8(c) to the accounts reflects deferred tax assets of $7.5m, leaving net deferred tax liabilities of$4.5m

So then the claims become $17.5m - $27m + $6.5m + $4.5m = -$1.5m, i.e., resulting in an EV of $101.5m which is clearly a big difference from the pre-adjusted result of $222m.

In most cases, in my experience, this sort of adjustment process will lead to more favourable, i.e. lower, EV outcomes.

Which is why the industry norm is to just include the net debt in the EV calculation, in the interests of conservatism and also simplicity, as follows:
EV = $100m + $17.5m = $117.5m

Of course, getting really technical for a moment, if the business was assumed to continue to operate indefinitely, then it would probably always be run at positive working capital levels, so the $27m net working capital credit should really not be booked. In this case the EV would be: $100m +$17.5m + $6.5m + $4.5m = $128.5m. This, I believe, is the most accurate EV for VMG.

However - and this is where the materiality comes in ? assuming VMG generates $45m in EBITDA this year and using your FCF measure of some $31.8m, this puts the stock on EV/EBITDA of 2.61x using the "industry norm" EV of $117.5m and 2.86x using the "more accurate" EV of $128.5m. Not much difference at all, especially given the margins of error in the assumptions behind the forecasting of EBITDA. Similarly, for FCF yields: 27.1% using the "industry norm" EV, and $24.7% using the "accurate method" EV.

Of course, in the interests of better understanding of the financial pedigree of the company one is looking at buying, I believe it will always be very good discipline to always drill down into the claims in this sort of fashion, to make sure that the materiality test is not breached.

Either way, in this instance the stock looks inexpensive. I hope it creates durable wealth for investors.

And I hope this somewhat convoluted explanation is of some use.

Prudent Investing

Cameron