Acquirer’s Multiple & the Quest for Value

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What You’ll Learn

An explanation of the Acquirer’s Multiple by Tobias Carlisle
A look at market cycles and valuations with the acquirers multiple in context
Understanding EBITDA yield and cheap stocks

In the great book, Deep Value, written by Tobias E. Carlisle, the enterprise multiple or the Acquirer’s Multiple, is discussed.

The acquirer’s multiple formula is defined in the book as:

Enterprise Multiple = EV ÷ EBITDA

EV = Enterprise Value = Market Capitalization + Debt – Cash

EBITDA = Earnings Before Interest, Taxes and Depreciation & Amortization

You may notice that this is pretty similar to one component of Joel Greenblatt’s Magic Formula:

Earnings Yield = EBIT ÷ EV

In another article, we review the research on the ability of Earnings Yield and the Enterprise Multiple to help identify undervalued stocks. The result? Both work quite well on their own.

Carlisle also asks this question: “Why is the enterprise multiple so good at identifying undervalued stocks?” He comes up with similar results.

By analyzing returns from different valuation multiples, he says:

We found that both variations of the enterprise multiple had the most success identifying undervalued stocks, with the value portfolios of the EBIT form generating a compound annual growth rate of 14.6 percent and the EBITDA form earning 13.7 percent over the full period (for context, the S&P500 Total Return Index earned 9.5 percent). Wall Street’s favorite metric—the price-to-forward earnings estimate ratio—was by far the worst performing of the price-to-value ratios, earning a compound annual growth rate of just 8.6 percent and underperforming even the market.

Let’s put this great book aside for a few seconds, and see an article from the Economist discussing the valuation levels from 2015 when this article was originally written. The information is still very relevant today.

Table of Contents show

The Economist: The New Rules of Attraction

A recently published article in the Economist, Mergers and acquisitions: The new rules of attraction, discusses the market valuation levels compared to earlier periods.

Whether deal making is sensible is once more an important question, because M&A are back with a vengeance after a lull following the financial crisis. Worldwide, $3.6 trillion of deals have been announced this year, reckons Bloomberg, an information provider, approaching the peak reached in 2007. In pharmaceuticals (see article) and among media firms the activity is frantic. Deals worth more than $10 billion are again common. America and Britain, with their open markets for corporate control, account for a disproportionate share of the action. So do cross-border deals, which have risen from a sixth of activity in the mid-1990s to 43% today.

The first part of the article discusses whether or not there are any value-added to be expected from mergers and acquisitions. A relevant question by any means. Here is what the article has to say:

On paper, M&A make sense. When two firms combine they can cut duplicated overheads, raising their margins. By adding together their market shares they can gain pricing power over customers and suppliers. By cross-selling each other’s product ranges in each other’s geographic markets, merging firms can make their combined sales a lot bigger than the sum of their individual ones.

M&A folklore, however, dwells on giant catastrophes, such as the combinations of Time Warner and AOL in 2000 just as the dotcom bubble burst, or Royal Bank of Scotland (RBS) and ABN AMRO in 2007, as the subprime crisis struck. Yet some of the world’s most successful firms are the result of giant deals. Exxon became the energy industry’s top dog thanks to its purchase in 1999 of Mobil, which had an under-appreciated collection of global assets. AB Inbev has done $100 billion of deals over two decades to become the world’s biggest brewer, with thirst-quenching profits.

The second part of the article discusses the cycles of history and looks at the current valuation level in deals that have closed. Having a firm grasp of how history played out, can sometimes serve as a guide going forward. Even if history doesn’t repeat, maybe it does rhyme? Anyways, about the cycles of history, the article says:

Cycles of History

The first test is whether a bandwagon is rolling, with corporate bosses jumping aboard unthinkingly. In America between the 1890s and the early 1900s there was a craze for creating monopolies, in steel, tobacco and other industries, prompting trustbusting laws to break them up. In the 1960s conglomerates were in fashion; by the 1980s these lumbering giants were also being dismantled, with the aid of the newly created junk-bond market. In 1999-2000, during the dotcom bubble, technology and telecoms firms accounted for 40% of activity, only to be among the biggest to pop subsequently. In the last surge of deals, in 2003-07, several bandwagons were rolling, including a rush into emerging markets and commodities, and a gallop into private-equity buy-outs. (These accounted for a quarter of deals in 2007, but are down to 19% so far this year.)

So far this time there is no widespread mania. There are pockets of silliness: the pharmaceutical industry is in a frenzy of “inversion” deals, in which American firms buy foreign ones in order to switch their domiciles and avoid American tax rules. But inversions account for only 9% of M&A activity so far this year.

Meanwhile, there are lots of relatively unadventurous deals, says Roger Altman, the boss of Evercore, an investment bank. These seek to build firms’ shares of existing markets, strengthen their product portfolios and cut costs rather than to enter completely new industries or distant countries.

Among the biggest of these, Comcast’s $68 billion bid for Time Warner Cable will, if regulators approve it, give the bidder control of 17 of the top 25 cable markets in America. GSK and Novartis, two drugs firms, are swapping assets to bolster their respective strengths in vaccines and oncology. Verizon’s $130 billion purchase of Vodafone’s share in their American mobile venture was the largest deal in 2013-14 but hardly a leap into the unknown: Verizon already manages the business.

In a further reflection of the restrained mood, some serial acquirers have gone into reverse, divesting or spinning off assets, notes John Studzinski of Blackstone, a financial firm. Dismemberments tend to be investor-friendly. Altria, a conglomerate that included Philip Morris and Kraft Foods, was created in a flurry of deals in the 1980s and 1990s. Since 2007 it has split itself into four main parts, that are today worth $333 billion, almost double what the combined group had been worth.

In October Hewlett-Packard said it would spin off its personal-computer business, reversing its acquisition of Compaq in 2001 (while also offloading its printers business). BHP Billiton, an Australian miner, has been one of the most acquisitive companies in history. But it now wants to spin off its metals and coal businesses, largely reversing a merger that created the firm in 2001 (though it shelved the sale of part of the metals business this week, after failing to get a good price for it).

The trend for spin-offs may have further to go. Plenty of multinationals plunged into emerging markets just before these countries’ economic growth rates slowed: now some of them will be getting cold feet. And many of Asia’s biggest firms, such as Tata Sons in India, Hutchison Whampoa in Hong Kong and Samsung in South Korea, are sprawling conglomerates that may in time be broken up.

The present M&A boom passes the first test: there is little sign of senseless bandwagon-jumping. The second sanity test is the extent of speculative financing and stretched valuations. Here the news is less good. Admittedly, the average premium paid by an acquirer as a percentage of the target’s share price, at 23%, is in line with the 20-year average. But this measure tends to be a poor guide to peaks and troughs. Two other measures are less reassuring.

First, lots of deals are being terminated or withdrawn—15% of total activity this year. For example, Rupert Murdoch’s 21st Century Fox withdrew a $94 billion offer for Time Warner, after Fox’s share price fell. A high failure rate is a sign of a toppy M&A market, with speculative bids made by nervous buyers. The failure ratio was last as high in 1999 and 2006-08.

Second, absolute valuations are creeping up to queasy levels. On average, companies have been bought this year at an enterprise value (roughly speaking, stockmarket value plus net debt) equivalent to 12 times gross operating profit, higher than at the peak of the last two booms (see chart 2). Successful deals are a union of two things: the business combination has to work, but so does the price.

At the peak of the boom in 2000, Wasserstein highlighted seven newly-combined firms he said exemplified an era of globalisation and technology. Since then one has been bailed out (Citigroup), one has gone bust (WorldCom) and two have been dismembered (DaimlerChrysler and Viacom-CBS). However sensible today’s M&A boom feels, as valuations creep into the danger zone, humility is in order.

Deep Value: The Acquirer’s Multiple

In Deep Value: Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations, the fourth chapter discusses “Why … the enterprise multiple [is] so good at identifying undervalued stocks?”. Here’s what it says:

Why is the enterprise multiple so good at identifying undervalued stocks? First, the denominator in the enterprise multiple—the enterprise value—provides a more full picture of the price paid than does the market capitalization. The enterprise value is closer to a stock’s true cost because, in addition to market capitalization, it includes other information about the contents of the company’s balance sheet, including its debt, cash, and preferred stock (and in some variations minority interests and net payables-to-receivables). Such things are significant to acquirers of the business in its entirety, which, after all, is the way that value investors think about each stock. The enterprise value can be viewed as a theoretical takeover price of a company. After a takeover, the acquirer assumes the company’s liabilities, including its debt, but gains use of the company’s cash and cash equivalents. Including debt is important here. Market capitalization alone can be misleading. Loughran and Wellman, citing Damodaran, give the example of General Motors, which in 2005 had a market cap of $17 billion, but debt of $287 billion. Market capitalization greatly understated the true cost of General Motors, but the enterprise value captured General Motors’ huge debt load, and so gave a more full accounting of its impact on General Motors’ returns. (The risk of a large debt burden moved from the theoretical to the real when General Motors filed for bankruptcy protection in June 2009.) Often a stock that appears superficially undervalued on a book value basis is recognized as being fully valued, or overvalued once its debt load is factored into the calculation. Other researchers confirm that enterprise value is superior to market capitalization, and especially so when companies carry dissimilar debt loads. It is the ease with which enterprise value makes a comparison of companies with differing capital structures that makes it so effective.

The measure of earnings employed in the enterprise multiple—operating earnings, whether defined as EBIT or EBITDA—also contains more information than net income, and so should give a more full view of the firm’s income. Neither EBIT nor EBITDA are impacted by non-operating gains or losses, where net income is impacted by non-operating losses. Nonoperating losses are important over a full operating cycle, but muddy the picture in any given year. Loughran and Wellman view operating earnings—EBIT or EBITDA—as a more transparent and less easily manipulated, shortterm measure of profitability, making a comparison of companies within and across industries possible. Critics point out that EBIT and EBITDA are measures of accounting profit and not a substitute for cash flow, which is where the rubber really hits the road. It would therefore make sense for any valuation proceeding from an enterprise multiple analysis to include some consideration of a company’s operating cash flow, and the extent to which accounting profits translate into cash generation.

Like a careful value investor, the enterprise multiple prefers companies holding cash and abhors companies with high levels of unserviceable debt. In practice, that tendency can be a double-edged sword. Enterprise multiple screens will contain many small “cash boxes”—companies with large net cash holdings relative to their market capitalization—often because the main business has been sold, or the business is a legacy in run-off that lingers like our vestigial appendix. Such stocks tend to have limited upside. On the flip side, they also have happily virtually no downside. In this way they are vastly superior to the highly leveraged companies favored by the price-to-book value ratio, which tends to serve up heavily leveraged slivers of somewhat discounted equity. The enterprise multiple is a more complete measure of relative value than the academic favorite price-to-book value, or any of the other common price-to-value ratios. The enterprise multiple includes debt as well as equity, contains a clearer measure of operating profit, and captures changes in cash from period to period. The empirical returns to portfolios created using the enterprise multiple bear out this rationale. Why does the simple enterprise multiple outperform the Magic Formula, the enterprise multiple and the return on invested capital combined? How can we reconcile the theory behind the deep value strategy—which amounts to fair companies at wonderful prices—with the theory behind Warren Buffett’s wonderful companies at fair prices strategy?

EBITDA Yield: A Historical Perspective

Patrick O’Shaughnessy published some great graphs (see here and here) showing historical EBITDA yields.

Here’s what Patrick wrote in 2014 about the market valuation.

Using this measure to look at all investable stocks in the U.S., it’s clear that the market as a whole has gotten more expensive since 2009. The EBITDA yield at the end of February, 2009 was roughly 14% for the entire U.S. market—today it is 9%. But the market’s overall valuation only tells part of the story. The market in 2009 offered a wide variety of valuations, whereas today, in 2014, the opportunities are much more clustered. Stocks today are more expensive, but valuations are also much more homogeneous.

O’Shaughnessy wraps up the post by saying:

This doesn’t suggest that you should abandon valuation as a key component in stock selection (quite the contrary), but it does suggest there is less of an edge today in cheap stocks than there was five years ago: there are far fewer U.S. stocks that are very cheap.

So What Is A Cheap EV/EBITDA Multiple?

Regarding what levels is considered a very cheap EV/EBITDA multiple, O’Shaughnessy says in another post:

I asked Tobias what he considers a very cheap multiple EV/EBITDA multiple, and we agreed that somewhere below 5x indicates a cheap stock, while a multiple of less than 3x indicates very deep value. So here is the problem: today, we face what is perhaps the most difficult environment for deep value investing in history. Just 3.2% of non-financial, U.S. companies with a market cap of at least $200MM trade at an EV/EBITDA multiple below 5x. That is just off June’s all-time low of 2.9%.

Acquirer’s Multiple & the Quest for Value

The Economist: The New Rules of Attraction

Cycles of History

Deep Value: The Acquirer’s Multiple

EBITDA Yield: A Historical Perspective

So What Is A Cheap EV/EBITDA Multiple?

Further Reading on EBITDA

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