WACC and Market Capitalization

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Let's look at the WACC and market capitalization for a company that has debt, preferred stock, and common stock outstanding. As our test case, we take a freeze-frame look at the capital structure of Consolidated Edison of New York (ED: www.ConEdison.com/), an electric utility provider that has plenty of debt and preferred stock, along with common stock. After studying ConEd's balance sheet, we return to our valuation of Cisco, which has a boring capital structure consisting solely of common stock.

Let's examine ConEd's capital structure as of December 31, 2001, and find the amounts of debt, preferred stock, and common stock outstanding. We look at its balance sheet (Exhibit 6-1) and income statement (Exhibit 6-2) to get the necessary information.

From the balance sheet, we find that ConEd has $5501 million of outstanding long-term debt. If we want a detailed description of a company's capital structure, we can access online its regulatory filings at the SEC. We examine Note B of ConEd's 10K for 2001 filed with the SEC through its EDGAR service. We see that ConEd has 25 different taxable debentures aggregating $4.105 billion with maturities from 2002 to 2041 and interest rates ranging from 6.375 percent to 8.125 percent. ConEd also is the obligor in $1.191 billion of tax-exempt debt that was issued on ConEd's behalf by the New York State Energy Research and Development Authority. The 13 tax-exempt issues have maturities from 2014 to 2036 and interest rates ranging from 1.81 percent to 7.5 percent. ConEd also has at least four series of preferred stock outstanding with an aggregate face value of $269.6 million. Is ConEd's capital structure confusing enough?

The income statement indicates that ConEd has 212.1 million average shares outstanding—basic, and 212.9 million average shares outstanding—diluted. We generally use the diluted shares outstanding when we look at capital structure and value a stock. This larger number better takes into account the effects of stock options and of convertible debt and preferred stock. ConEd's balance sheet shows that the book value of the common stock outstanding is $5666 million. On August 26, 2002, the stock of ConEd closed at a price of $42.53 per share. The market equity of ConEd's stock is:

212.9 million shares outstanding * $42.53 = $9,054 million

Condensed Consalulaled Balance Sheet c^hmc^inc.

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EXHIBIT 6-1 ConEd Balance Sheet

EXHIBIT 6-1 ConEd Balance Sheet

Market Value versus Book Value

Financial theory states that the market capitalization of a company is equal to the total market value, not book value, of the outstanding debt, preferred stock and common stock of the company.

Market Capitalization = Market Value

(Common Stock + Preferred Stock + Debt)

The FCFF approach uses the various market values to calculate a company's market capitalization, along with debt and equity weightings. To illustrate this point, consider the book value $5666 million ver-

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EXHIBIT 6-2 ConEd Income Statement

EXHIBIT 6-2 ConEd Income Statement sus market value $9054 million of ConEd's common stock. ConEd's book value versus market value ratio ($5666/$9054) is 62.6 percent.

The book value of debt and preferred stock is an accounting measure that relates to how much money was raised by the company when each security initially was issued. The book value of common stock is also an accounting measure that relates to the amount of money raised when the stock was issued, plus the amount of aggregate earnings that have been retained over the life of the company.

The market value of debt and preferred and common stock is the price at which the specific obligation would trade in today's market, times the amount outstanding. Because of the frequent trading of stocks and the fact that stock prices are readily observable, it's easy to determine the market value of common stock. Since debt and preferred stock trade less frequently and often only in the dealer-to-dealer market, market prices of these securities are not easily observable and are harder to determine.

If we're expecting a 10-percent return on a share of ConEd, and its market value is $42.53 per share, our expectation is that we will earn 10 percent per year on our $42.53 market value, or $4.25 per year between dividends and stock price appreciation. We'd be disappointed if we received 10 percent on the lower $26.61 book value of the share, or $2.66 per year. Hence, professionals use market values when they look at market capitalization of common stock.

Market versus Book Value: Our Recommendation

In real life, as opposed to the ivory tower of academia in which some of us reside, the current quotes of market value for debt and preferred stock are often difficult to obtain. Absent credit concerns and default risk, the market values of preferred stock and debt for the most part do not stray significantly from their respective book values. In an effort to conserve time and to simplify a valuation, most market professionals use the company's reported book values for debt and preferred stock when they examine the capitalization of the corporation.

Market professionals always use the market value of common stock when they examine the capitalization of the corporation. As we will see in valuation examples, the market value of common stock sometimes bears little relationship to its book value. Stock prices are readily available. In keeping with this market practice, we use book values for debt and preferred stock and market values for common stock in all of our valuation examples.

Market Versus Book Value for ConEd

We use the book values of ConEd's debt and preferred stock outstanding and both the book value and market value of common stock to develop ConEd's market capitalization schedule, as shown in Table 6-1 below.

Market versus Book Value for Cisco

Cisco, like most tech companies that have a high degree of business and operating risk, has no debt or preferred stock outstanding. According to Cisco's balance sheet (Exhibit 5-4), as of July 27, 2002, the book value of Cisco's common stock was $28,656 million and, ac-

TABLE 6-1 Consolidated Edison, Inc. Market Capitalization

12/31/2001 (millions of dollars)

Book Value

Market Value

Total

%

Total

%

Debt

$5,501.2

48.6%

$5,501.2

37.1%

Preferred stock

$249.6

2.2%

$249.6

1.7%

Common stock

$5,566.2

49.2%

$9,054.6

61.2%

Total capitalization

$11,317.0

100.0%

$14,805.4

100.0%

cording to its income statement (Exhibit 5-2), it has 7301 shares outstanding in its per-share calculation-basic, and 7447 shares outstanding in its per-share calculation-diluted. We use the higher diluted number to determine Cisco's market equity. Cisco's closing stock price on August 14, 2002, the date we valued Cisco, was $14.45, resulting in total market equity for Cisco's stock of $107,609 million (see Table 6-2 below). The book equity to market equity (BE/ME) ratio for Cisco, a high-tech company that prior to 2002 had very high growth rates, is: ($28,656/$107,609) = 26.6 percent, significantly lower than the 62.6-percent ratio for ConEd, which no one would mistake for a growth stock.

TABLE 6-2 Cisco Systems Market Capitalization

7/27/2002 (millions of dollars)

Book Value

Market Value

Total

%

Total

%

Debt

$0.0

0.0%

$0.0

0.0%

Preferred stock

$0.0

0.0%

$0.0

0.0%

Common stock

$26,656.0

100.0%

$107,609.2

100.0%

Total capitalization

$26,656.0

100.0%

$107,609.2

100.0%

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