The following has been drafted as a courtesy for those members on Rennteam without a professional grounding in financial analysis... (and is intended to complement CGX car nut's insightful post)

It is important to keep in mind the difference between Book Value and Market Valuation.

Book Value is based on a company's Balance Sheet, where in simple terms:

  • Book Value of Equity = Net Assets = Total Assets - Total Liabilities

...so Book Equity can indeed be less than Zero, in the case where Total Liabilities exceed Total Assets.

Market Valuation can be derived from a DCF analysis of discounted future cash flows, or by using multiples (e.g. EV / EBITDA, EV / EBITA or P/E multiples) of comparable companies, which can be current trading multiples or acquisition related multiples.

When considering Market Valuation, it helps to keep in mind the following:

  • Enterprise Value = Equity Value + Net Debt

...implied Equity Value can be less than Zero, in the case where Net Debt exceeds the Enterprise Value. Since the market value of a share cannot be negative, in this scenario the market value of the debt drops below its face value, i.e. the value of debt is impaired and the equity is worth zero.

Hence, while it may seem logical that a share in a company with assets must always be worth something, that is not correct. If the company has liabilities that exceed total assets, or net debt that exceeds enterprise value, the value is likely to break in the debt during a financial restructuring, in which case the equity is worth zero.

So what might cause a company with functioning operations, revenues, customers, orderbook, brand, etc to end up in a financial restructuring?

Such an event could be caused by insufficient liquidity where the company can no longer fund working capital, service interest on debt, fund capex, pay employees, pay suppliers, pay taxes, etc.

A company that faces a liquidity crisis can still have a significant Enterprise Value, but that can also be below the value of total liabilities, where the equity would be worth zero.

A financial restructuring could also be caused by a breach of financial covenant or a payment default in a debt agreement, leading to an event of default. If the company is not able to remedy such a covenant breach or payment default and cure the event of default, the debt holders are likely to take control of the company and force a financial restructuring. In such a scenario, the shareholders are indeed often looking at a zero and the share price will usually react accordingly.

One final question: how might an amateur investor, a customer, or indeed a supplier understand when a company might be getting close to such an unfortunate event as a financial restructuring? Keep a close watch on the public credit ratings. Read the rating agency reports to understand the highlighted risks. What factors might result in a downgrade? How good is the management at meeting the projected financial performance that a credit rating is based on? Rating agencies have little interest in the equity upside or the share price. The rating agencies will be focused on understanding the "credit" and the downside risks.

Hence, an investment grade company (e.g. VW is rated A3/BBB+) will usually have a great deal more financial flexibility (and ability to survive a downturn in financial fortunes) than a sub-investment grade credit like Tesla.

To fully appreciate the financial profile of a company, it is important to understand the business and industry, along with both sides of the Balance Sheet, the Profit and Loss statement and the Cash Flow statement.

For reference, Tesla Inc will report 2018 Q1 financial statements on 2 May 2018.