The Limits of Market Capitalization

Kevin Maney today looks at the mooted $17.7 billion valuation of a merged Delta and Northwest, and contrasts it unfavorably with the market capitalization of Yahoo. "It's almost hard to believe that all those planes, all those people, all that activity, would be worth one-third what Yahoo is worth," he says.

Let's not niggle over the actual ratio: what this points up is that in Kevin's beat of Silicon Valley, the value of a company generally is its market capitalization, because it's extremely rare for technology companies to raise much if any debt. That makes it very easy to compare the value of any two companies: whichever one has the higher market cap is worth more.

In the real world, of course, companies have lots of debt, and very complicated capital structures, which means that market cap is a much less useful metric. Enterprise value is much more useful: essentially, the amount of money you'd need to buy the company. As a first approximation, we can consider it to be market capitalization, plus total debt, minus total cash.

Delta Airlines, for instance, has total debt of $9.3 billion, while Northwest has total debt of $7.1 billion. Add that total debt to a market capitalization of $17.7 billion, subtract cash of $5.8 billion, and you get a total enterprise value of $28.3 billion. Yahoo, by contrast, has a market capitalization of $37.7 billion, total debt of $0.7 billion, and cash of $2 billion, for an enterprise value of $36.4 billion. Bigger, but not remotely three times bigger. And if you add in liabilities not included in "total debt" - things like future pension and healthcare costs for retirees - then the merged airline I'm sure easily eclipses Yahoo in size.

Alternatively, look at the area which investors really care about: earnings. Yahoo had net income of $660 million in 2007; Northwest earned $2.09 billion, while Delta made $1.61 billion. In other words, the airlines, between them, made well over five times as much money as Yahoo, and that's after paying interest on their debts. (Admittedly, Delta lost $6.2 billion in 2006, and Northwest lost $2.8 billion, so it's not clear how sustainable those profits are.)

While market capitalization is useful when looking at technology companies, then, it's not particularly useful when looking at airlines. And it's certainly not a great way of comparing the two.

Update: See also Barry Ritholtz, "Apple Now Bigger Than Citi".