Negative EV Companies: Are these really good investment opportunities?

In today’s global economic scenario, ‘Cash is King’, and why not? Overall, the liquidity has dried, and companies are finding it difficult to fund even their working capital requirements, leave alone acquisitions, expansion and growth plans. According to a recent article on Bloomberg, ‘Cheapest Stocks Since 1995 Show Cash Exceeds Market’, dated Dec 8,2008, stocks have fallen so far that approx 2,267 companies around the globe are offering profits to their shareholders ‘for free’. This is eight times as many companies as compared to the ones noticed at the end of the last bear market in 2001. The article speaks about companies with a negative EV, especially in the Financial Services sector such as Asset Managers, Banks, Consumer Finance, Financial Administrators, Investment Services, Mortgage Finance and Specialty Finance companies. The companies with negative EV span across various market caps, i.e. Nano (market cap < 50 mUSD), Micro (market cap 50 mUSD - 300 mUSD), Small (market cap 300 mUSD - 2 bUSD) and Large. The companies covered in this study prominently include approx 50 companies with a market cap of more than a billion US dollars. Also, the companies covered under this study belong to a plethora of industries ranging from, Financial Services as the most dominant one followed by Metals and Mining, Computer Hardware and Services, and Electronic/Electrical Components and equipment to name a few. Since the maximum number of companies in the negative EV category, belong to the Financial Services sector, we intend to focus on the Financial Services sector in this part of our discussion, and include the other sectors in subsequent discussions.

Is the supporting data misleading?

We noticed that some or most of these companies with negative EV’s covered in our study were actually profitable. Since EV is a function of Market Capitalization, Debt and Cash, for a firm to have a negative EV, its market cap and debt need to be substantially low vis-à-vis its cash position. This phenomenon is generally seen in cash rich companies. We were rather intrigued to see that most of the companies with a negative EV belonged to the Banking sector, and with further research, we noticed that the financial information used, which was sourced from Bloomberg along with other similar financial information providers were applying a standard calculation for a classical company to a bank.

Can banks have a negative EV?

Banks can’t have a negative EV, as their EV is effectively their market cap and a share price cannot fall below zero which makes negative EV an impossible feat to achieve. Banks are unusual in that they don’t have ‘net debt’, as the product they ‘buy’ as in deposits or ’sell’ as in lending is ‘cash’. What banks are owed should be higher than what they owe and this is the book value of equity, and it’s EV. As financial information providers don’t differentiate between different industries in their calculations they can come out with negative numbers for banks. Hence, we need to treat their numbers with a pinch of salt, particularly the EV and beta numbers. One probable reason for this being, the financial information providers are attempting to oversimplify the industrial or sectoral categories for better and comprehensive understanding, but in their attempt to do so, may mislead the investor into taking fallacious investment hypotheses.

Why do banks have so much cash?

Another observation made for the banks with negative EV is that in times of a recession or a global slowdown, such as the one we are experiencing, stock markets plunge and stocks trade at extremely low values, thus reducing the market cap of the companies. With a large number of financial institutions failing and filing for bankruptcy, banking stocks are trading at extremely low levels, shrinking the market cap of these banks. Thus, the first factor (market cap) in the EV calculation is affected significantly. Secondly, in todays economic markets the demand for debt by corporations, is relatively high, but the borrowers may not necessarily qualify for the stricter covenants setup by banks and other financial institutions. This is a ’structural problem’ faced by the overall Financial Services sector particularly the banks. Hence, even if banks do have potential customers or corporations willing to borrow, lending is slow, leading to high cash balances. On the contrary with increased cost of borrowing and uncertain demand, borrowers have also slowed down capacity expansion or acquisitions reducing the demand for banks cash. High cash balance combined with relatively low market cap results into negative EV, if the standard EV calculations are applied to a bank.

Banking sector

Speaking about the banking sector alone, we also felt a need to justify as to why these banks with negative EV have such high levels of cash. Do these banks maintain a high percentage of their cash and equivalents with the respective central banks in terms of SLR or CRR? Post data analysis, we noticed that the cash component in the banking companies used for EV calculations, by Bloomberg and other similar databases and search engines, consisted of cash and balance which the banks maintain with their respective Central bank in terms of a CRR or SLR, which is a mandatory requirement. Inclusion of these cash reserves, in the overall cash position of the Banks by any means, is natural and expected. However, in an economic downturn like today’s, the market capitalization of these Banks and Financial Institutions would shrink significantly and in many cases would seem trivial compared to the total cash held by these banks, including the cash deposited with the respective Central Banks in the form of CRR and SLR. This may further create a negative EV for the Bank. We also feel that, the degree of negative EV would increase or decrease over different geographical regions depending on the CRR & SLR limits set up by the central banks in respective regions.

Geographical distribution of negative EV companies in the banking sector

The geographical distribution of negative EV companies in the Financial Services industry represents a significant number of companies (38) in East Asia, with companies primarily based out of Japan. A close second is North America (US) with 34 companies. South East Asia which consists of Indonesia, Malaysia, Philippines and Vietnam has around 19 companies and South Asia comprising of India and Pakistan has 16 companies falling in the negative EV category. Other notable regions include North Africa and South America which consist of 14 and 13 companies respectively in the negative EV category.

This entry was posted on Monday, January 5th, 2009 at 4:48 am and is filed under SGA Knowledge. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.