March 2024
Why do some companies borrow and others sell shares?
7cm doesn't seem like much extra width, but you notice it when parking next to it. From Carsized.
Tesla just grows and grows. Journalists are not made of stone; who could resist
the obvious car analogy?:
Tesla overtakes GM as most valuable U.S. automaker, short sellers
burned, Reuters, October
2019
Tesla overtakes Volkswagen as value hits
$100bn, BBC, January 2020
Tesla overtakes Toyota to become world’s most valuable
carmaker,
Financial Times, July 2020
That 2019-2020 period was not an temporary aberration. Tesla's share price has
held stable and it is still more valuable than all of these car companies
today. At least, by the measure that the journalists are using.
These articles are comparing the "market
capitalisation",
or "market cap" for short. "Market cap" is the total value of all the shares
that the company has issued. Price per share multiplied by the number of
shares:
market cap = share price * share count
Here are there market caps for these four carmakers as of today:
Carmaker
Market cap ($bn)
General Motors
45
Tesla
558
Toyota
329
Volkswagen
65
If you wanted to buy Toyota, $329bn is the price you'd have to pay to get all
the shares and assume total control (worth it to get the
Previa back into production).
Market cap seems, on the face of it, like the right measure of "valuable".
The problem is that the market cap isn't the whole picture and consequently it
is a bit of a "vanity
metric".
The missing billions
When you are running a company there are two different ways to raise money:
Sell shares
Borrow money (ie: take a loan from a bank, issue bonds, etc)
Carmakers in fact traditionally prefer to borrow money rather than sell shares.
Here are our four carmakers, but with their borrowings as well as the market
cap:
Carmaker
Market cap ($bn)
Borrowings ($bn)
General Motors
45
122
Tesla
558
9
Toyota
329
200
Volkswagen
65
194
Nine billion is a lot, but Tesla is in fact slightly unusual in having very
little debt relative to its market cap. General Motors clearly has a bit of a
preference for borrowing - its borrowings are twice its market cap. That is
not necessarily an excessive level.
If you paid $45bn and bought all the General Motors shares you would have total
control over the business. But you wouldn't have total control over all the
profit. Most of "your" profit would be going out the door to people who had
lent GM money in the past. So you can think of market capital as the "control
price". But it's not the real price to get all the proceeds of the business -
ie: all the value.
The price to buy the business and gain all its economic value is the
enterprise value. That is the market cap, plus the price of the debt minus
the cash. Minus the cash? Companies routinely hold largish amounts of cash
(or "cash equivalents") on hand and you just discount that from the price
because you'd get that sum returned to you instantly if you bought it.
enterprise value = market cap + borrowings - cash
Here are the enterprise values of these companies (please scroll the table
horizontally on mobile):
Carmaker
Market cap ($bn)
Borrowings ($bn)
Cash ($bn)
Enterprise value ($bn)
General Motors
45
122
26
142
Tesla
558
9
15
553
Toyota
329
200
62
466
Volkswagen
65
194
77
188
Yes, Tesla is more valuable than Toyota. But Toyota is much closer than it
looks based on just market cap.
Why borrow money instead of selling shares? Or vice versa?
Imagine you're the chief exec of a carmaker - should you finance your new
yottafactory via selling shares, or should your instead borrow money from the
bond market?
As a competent chief exec you will be telling the public frequently and often
that your company is well worth its share price, and then some. You will sing
grand songs about the future, about chatbots, about self-driving cars, about
blockchains, about generative AI, whatever. Anything to support the share
price. Or better yet, increase it.
But your finance director (who is dour, and keeps tweeting about IFRS
guidelines on revenue recognition) will have an internal model for what the
company is really worth. If your market cap is much higher than his private
valuation, he will advise you to issue shares instead of issuing bonds.
A high share price relative to your true value constitutes the ability to
finance cheaply.
Companies do tend to recognise when their shares are overpriced. They start
doing funny things, like acquiring other companies in "all-share" transactions.
Those are the kind where you buy someone, but pay with your own shares.
Singleton-minded
One of the companies most successful at optimising its own financing was
Teledyne.
The 1960s were a time of huge hype for "conglomerates" - companies consisting
of many different and unrelated subsidiaries. The theory at the time was that
there were big synergies between these constituent businesses.
The classic 1960s example of synergy was between selling microwaves and also
microwave dinners. The plan was to make a killing cross selling microwave
dinners to the people you'd already sold microwaves to. Please understand:
this made more sense at the time.
Due to this
mania, the shares
of conglomerates at the time were valued at very high multiples on their
earnings. Their market caps would be 15 times their annual profit, or more.
They would then use their overvalued shares to buy up ordinary,
non-conglomerated, businesses whose market caps were based on lower multiples
due to their acute lack of microwave synergies.
After completing each acquisition the newly embiggened conglomerate would then
add the earnings of their new subsidiary to their own and enjoy their new, even
higher market cap. Everyone is chuckling because now that business that was
valued at 8 times earnings is now valued at 15. Value creation for
shareholders - brill!
Teledyne bought a lot of stuff during this area, inhaling over a 100 other
companies and bloating up itself substantially. At the highest point in the
bubble period Teledyne's share price was $130.
The bubble popped around 1970. It had become clear to all that there was no
specific reason for you to buy your dinner from the man who'd sold you your
microwave.
Responding to its new, post-bubble, lower share price, in 1971 Teledyne
disbanded its mergers and acquisitions team. Unable to pay with its own
overvalued shares, it never bought anything again.
Instead, with its internal models showing that Teledyne's own stocks were now
dramatically undervalued, it started to buy them back at the new, lower,
price of $15 a share. In fact Teledyne even took out loans in order to fully
capitalise on its own low share prices.
Teledyne continued its monster share buyback for another decade or so before
finally spinning out many of the businesses it had bought and issuing a
chonking great dividend in the late 1980s.
Teledyne's return over the period was phenomenal:
Notice how small the 1960s bubble is, compared to Teledyne's
later rapid appreciation
The founder of Teledyne, Henry
Singleton, didn't do too
badly out of it. He used his share of proceeds to buy a big ranch in New
Mexico.
Wealthy billionaires nowadays don't like to retire to the country. They tend
to use their built-up wealth and power to selflessly tackle humanity's hardest
problems: eradicating malaria;
reducing the costs of
spaceflight; arresting climate
change; improving state
education or moderating Twitter.
Contact/etc
Other notes
Many of the great and the good have been caught out by Tesla's meteoric rise.
David
Einhorn is a
respected financier. He is most famous, at least in my mind, for publicly
announcing doubts about Lehman
Brothers which hastened their
collapse. He had a long-standing and public short position on Tesla which I
think ran for multiple years and ended in a big loss. In 2018 an American
clothing brand got some viral marketing by sending
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