Investors looking to play a beaten down sector like coal need to understand the difference between Market Cap, “MC” and Enterprise Value, “EV.” Most investors recognize MC, the number of shares outstanding multiplied by the share price. This simple metric serves investors well if there’s not much debt on the balance sheet.
In short, market cap ignores debt on the balance sheet
However, if a company employs debt, then MC alone will not suffice in comparing investment opportunities. EV = MC + debt – cash (& cash equivalents). Therefore, EV explicitly takes into account debt and cash, both of which are of vital importance these days. Peabody Energy Corporation (NYSE:BTU), Arch Coal Inc (NYSE:ACI) and Walter Energy, Inc. (NYSE:WLT), stocks are down 81%, 94% and 91%, respectively, from all-time highs. Naturally, these stocks may appear to be quite cheap or oversold.
Comparing EV to MC puts these dismal stock charts into perspective. Back in 2008, Peabody Energy Corporation (NYSE:BTU) traded at an all-time high of $88 per share, on 272 million shares, for a MC of $24 billion. Friday, the share price was $16.8 and there are 270 million shares, for a MC of $4.5 billion. Looking at EV, at Peabody’s peak, the EV = MC + (debt-cash) was $27 billion! of which the (debt-cash, aka, “net debt”) component was $3.2 billion. Thus, net debt was 11% of Peabody’s total EV.
The Relative proportion of debt as a percentage of EV has soared
Friday, Peabody Energy Corporation (NYSE:BTU)’s EV = MC of $4.5 billion + net debt of $5.5 billion = $10 billion. Therefore, while Peabody Energy Corporation (NYSE:BTU)’s stock price is down 81%, it’s EV is, “only” down 63%. While that might not seem very helpful to know, that’s just part of the story. It’s essential to also understand the relative weight of the net debt in the capital structure. From 11%, that figure has spiked to 55%. Therefore, the relative weight is up by a factor of 5.
Without any further calculations, one can see that the financial strength of Peabody Energy Corporation (NYSE:BTU) has plunged along with its stock price. Therefore, the earnings multiple an investor should be willing to pay is lower. This is an essential exercise for framing the rebound potential of Peabody Energy Corporation (NYSE:BTU)’s stock. Will this stock bounce back into the $80’s? Not a chance. Earnings prospects are far weaker and relative net debt is 5 times higher. Investors hoping for a 3-5 times stock return in Peabody are in for a big disappointment.