Tuesday, June 13, 2017

Stocks versus Bonds (And Enterprise Value)

Are there really significant differences between stocks and bonds?  Yes and no.

In a previous posting I mentioned offhand that Stocks and Bonds are really not that much different, and perhaps this is one aspect that has changed modern business life.  Today, companies are just as likely to raise money through debt offerings as through stock offerings, and there are advantages to debt over equity, for both the company and the debt-holder.

First, let's examine how both Stocks and Bonds are similar, if not identical in nature.

1. Both can be traded.   Stocks and Bonds can be bought when they are first issued or traded on the open market.   The value of either varies based on the health of the company and its perceived value, as well as yield.   With regard to the latter, prices may vary depending on what competing investments are offering.   When interest rates went through the floor in the last few years, stock prices and bond prices climbed, even if the effective P/E ratio or yield rates dropped.

2.  Both can be used to raise equity.   In theory, an IPO is supposed to sell off equity stakes in a company so the company can build factories and start a business.  Additional stock can be sold to expand.   Bonds can be sold for the same reason.   The reality of IPOs is that they are often self-serving, providing the owners of the company a means of cashing out.  And as we will see, offering debt is often another way for the owners of a company to benefit themselves.

3.  Both represent ownership of the company, to some extent.   This may seem non-intuitive at first as equity shareholders would seem to be owners and bond holders merely holders of debt - contracts to pay back a sum certain.   But if you really wanted to "own" a company outright, you'd have to buy out all the shareholder and pay off all the bondholders.  And in bankruptcy, a bondholder is often converted to a shareholder, ending up as an owner of the company.

All that being said, what are the differences?  Well, they are pretty obvious, but maybe not as significant as they seem.

1.  Shareholders can vote, bondholders cannot.  This is true, but unless you own a huge stake in a company, odds are your "vote" doesn't count for anything - anymore than my vote for President did, in a red State.  The vaunted "control" is really illusory.   And in fact, in bankruptcy, bondholders have more of a say than shareholders.   In fact, shareholders often have no say, are wiped out, and any bankruptcy settlement often has to be approved by the bondholders (which nearly tripped up the GM reorganization).

2.  Bondholders are paid a fixed amount of interest.   This is also true, but since bonds are traded, the effective yield depends on what you paid for the bond.  When Mohegan Sun nearly went bankrupt, the effective yield on some bonds was over 200%.   So the effective amount of money you get in interest is going to depend on the perceived value of the bonds, which is based on the perceived soundness of the company and also prevailing bond rates.  That is, unless you bought an initial issue of a bond and held it to maturity - something few people do.

3.  Stocks can pay dividends.   This is also true, but really a dividend is not to dissimilar from an interest payment.  Dividends are going to be based on profitability, though, and interest payments are due even if the company is losing money.  Note, however, some Directors have been known to declare dividends even as a company loses money!  The amount of the dividend is at the discretion of the Board in most cases, and as percentage of share price will reflect market values (that is to say, share price will change based on profits and dividends).
4.  Stocks can go way up in value, Bonds, not so much.  If a company grows wildly and expands and makes huge profits, the stock value can go way up.  It can also go way up if the stock is merely hyped by the media.  It can also go all the way down to zero.  There is more risk and volatility in stocks than in bonds.   Bonds can go up in value, if interest rates drop, for example.   If you are holding a 5% bond in an era of 2% returns, the value of your bond will increase - to more than you paid for it.  If interest rates go up, your bond may be worth less.

So there are two ways of raising money for a company - stocks and bonds.  There are also conventional bank loans, which some companies use, along with private loans, such as those the CEO of Sears is making to himself.   And in this regard, all sorts of shenanigans can be cooked up with both stocks and bonds in this modern world.

IPOs, I have written about before.   They puzzled me until I realized that the IPO of most tech companies sells off a pitiful 5% or so of the business, while the founders keep 95%.  So much for your voting rights, eh?   Do you really have an equity stake in such a company, or are you just deluding yourself?

But debt can be used to fool around with company finances as well, and again, at first this seems counter-intuitive.   You buy stock in a company, get control of the Board, appoint your own people as CEO, and then load the company up with debt.  It could be your debt (money you lend) or bonds sold to the public, banks, or private investors.  This might make the balance sheet look better, so you sell your stock and cash out.  Or you pay yourself a ton of money in salaries and cash out.  Or you take the company private, reorganize it, hype the snot out of it in the financial media and then cash out in an IPO offering.

Or you can intentionally bankrupt the company - a bust-out.  You strip off the valuable assets and divisions and sell them off, showing a "profit" which you pay to yourself in dividends as well as in interest on the debts you loaned to the company (at junk-bond rates, of course).   Now loaded up in debt, with no realistic way to pay it off (all the profitable divisions were sold off) you declare bankruptcy, stiff all the suppliers and the union pension plan.   In bankruptcy court, you, as a creditor, become a shareholder in the company - perhaps a majority shareholder - and own it outright, stripped of all that nasty pension debt and union contracts torn up on the Judge's bench.   Pretty sweet deal!

Loading up a company with debt is also the way you can buy it.  You offer to "take the company private" by buying out the shareholders.  Maybe the company isn't doing very well and you feel it is undervalued.  Or management doesn't have the courage to shut down money-losing divisions.   Or maybe you are planning a bust-out.   You offer a 10% premium over the current share price and the majority shareholders (all three of them) say "Yes".   The "little guy" who owns 100 shares that he bought for 20% more than current market value doesn't get a say in the matter.

To finance this buy-out the company issues bonds or takes on some other form of debt.   Equity is converted into debt, overnight, and the people "taking over" the company really didn't put much of their own cash into the deal.   It is so bizarre sounding you have to wonder if it is even legal!  Of course, the problem is, the company is now crippled with debt, often at junk-bond rates, and has to struggle to pay the interest on these notes.   They slash costs, sell off divisions, and try to improve profitability in order to pay this debt.   They can go to the union and plead poverty, as they have basically impoverished themselves.   It is sort of like a person arguing they should get food stamps because what with the payments on their new Camaro, they are hardly making ends meet!

There are all sorts of games you can play, few of them favor the small investor.

But is there a difference, really, between equities and debt?  And why does the financial media obsess about equities and ignore bonds?   Well, they do this because stocks are perceived as sexy and bonds as boring.  But but are relevant in determining the health and value of a company, and both can be useful investments.

Lately, as you know, much hoopla has been made about Tesla exceeding Ford Motor Company in "value".   But how is this "value" calculated?   The simpleton financial press takes today's share price and multiplies it by number of outstanding shares and calls this "Market Cap" and says that is what a company is worth.   But is it?   As I noted before, it is a misleading, if not irrelevant, number.

Ford has a "Market Cap" of $45.65 Billion and a debt-to-equity ratio of 4.768.  That means they have almost five times as much debt as they have outstanding shares at the current share price. or about $217.65 Billion in debt (ouch!).

Tesla has a "Market Cap" of $61.10 Billion and a debt-to-equity ratio of 1.634, which means about $99.83 Billion in debt.

If you add the "Market Cap" to the debt load, you can see that the "price" to purchase each company, debt-free is far different than the "Market Cap" alone would suggest.  Some folks call this Enterprise Value - the sum of the two.   Note that some folks have even more convoluted formulas for calculating enterprise valueThe point is, "Market Cap" isn't the end-all.

And as you can see, Ford has an "Enterprise Value" of  $263.3 Billion while Tesla's value is "only" $160.93 Billion.  Even so, Tesla may be very over-valued, with a P/E ratio over 300, while Ford is hovering around 11.   The market is irrational.

(Other sites list Ford's "enterprise value" at $150 Billion and Tesla at  $66 to $69 Billion, depending on whose site you are on.  Note that these calculations put Ford at nearly three times the value of Tesla, not vice-versa!).

But it illustrates that if you wanted to take over Ford Motor Company, you would have to only come up with about $50 Billion (actually far less, as you can leverage yourself), instead of the overall Enterprise vale of over $200 Billion.   Stocks to represent control for the large investor.  Bonds usually do not.

So, does this mean you should buy stocks or bonds, neither or both?   It is hard to say.  Likely, if you are invested in one or more mutual funds, unless the fund is restricted to one or the other (a stock index fund, for example) likely you are already invested in both.  But increasingly, I am not seeing much of a difference between the two.