Enterprise Value and Acquirer’s Multiple. Using Total Enterprise Value / EBIT as the primary tool to evaluate and compare the earnings power of a company.

Investors should make the ratio of a company’s TEV/EBIT a primary tool to evaluate its earnings power and to compare it to other companies instead of PE ratio.

Buffett has said that he will generally pay 7x EV/EBIT for a good business that is growing 8-10% per year.



Enterprise Value

Total Enterprise Value

The simplistic PE ratio is useful as crude screening tool but it has a serious limitation of ignoring the balance sheet items. This can materially misrepresent the earnings yield of a business.

One way to look at it is considering the total enterprise value (TEV) of two companies, A and B and see which one is cheaper to buy the whole business as explained in Investopedia as below:

[Think of enterprise value as the theoretical takeover price. In the event of a buyout, an acquirer would have to take on the company's debt, but would pocket its cash. EV differs significantly from simple market capitalization in several ways, and many consider it to be a more accurate representation of a firm's value. The value of a firm's debt, for example, would need to be paid by the buyer when taking over a company, thus TEV provides a much more accurate takeover valuation because it includes debt in its value calculation.]

TEV = Market Capitalization + Debt + Minority Interest - Cash – other non-operating assets

• The market capitalization is the market value of the common shareholders’ equity equals to number of shares multiply by share price.
• The debts is the market value of interest bearing bank loans, bonds, commercial papers etc. In financial solid businesses the market value of debt corresponds to its book value.
• Minority interest is the result of the consolidation of the subsidiary company’s account and it doesn’t belong to the common shareholders of the company. The market value of MI is obtained by multiplying its book value by an appropriate price-to-book value.
• Cash and cash equivalents are deducted from the enterprise value as they lower the purchase price. They can be distributed or used for the reduction of debts in an acquisition.
• The other non-operating assets are treated in a similar way, as they can be sold without impacting the cash flow situation, for example properties, investments in associates etc.

Acquirer’s Multiple (TEV/Ebit)

So why is the Acquirer’s Multiple so important? For a couple of reasons. First, it allows us to see how cheap a stock currently is. Unlike a discounted cash flow analysis, calculating a stock’s current TEV/Ebit requires no estimates into the future.

Secondly, I often use TEV/Ebit as my main valuation tool to compare the relative price-value relationship of companies in the same industry to see which one is a better buy.

For individual cases, I will be happy to invest in a company with normal growth rate of say 8% with TEV/Ebit < 7, following Warren Buffett's metric.  Flip it over, we get an earnings yield for the enterprise of 14%, or an after tax earnings yield of 11%., which I am satisfied of.

Conclusions

Investors should make the ratio of a company’s TEV/EBIT a primary tool to evaluate its earnings power and to compare it to other companies instead of PE ratio. This is the ratio that Joel Greenblatt uses for his Magic Formula by flipping it over and that Buffett uses when evaluating a business. Buffett has said that he will generally pay 7x EV/EBIT for a good business that is growing 8-10% per year.

Balance sheet is also a very important part of our analysis, not only to avoid liquidity and bankruptcy risks in times of economic downturn and financial crisis, but also for a price Vs value investing decision.

Reference:

Enterprise Value and Acquirer’s Multiple kcchongnz

http://klse.i3investor.com/blogs/kcchongnz/84689.jsp

Investing and The Eighth Wonder of the World kcchongnz

http://klse.i3investor.com/blogs/kcchongnz/92412.jsp

Quick and Steady return

Figure 1 below shows the typical 10-year return of a “Quick” speculator and a “Steady” long-term investor, both starting with RM100000.

Quick aims for fast gain, getting in and out of the market, buys and sells based on what the charts tell him to, and always looking for “the next big thing”. It has a higher average return over the 10 years of 15% a year, higher than the average, and more steady return of the long-term investor, Steady, of 10%. Table 1 in the Appendix shows the hypothetical annual return of both the market players.

At the end of 10 years, Figure 1 shows that the RM100000 invested by Steady has accumulated to RM253000, 37% more than what Quick has accumulated in the amount of only RM106000. The compounded annual rate (CAR) of Steady is 9.7%, whereas Quick could only achieve a CAR of just 0.6%, although it has a much higher average return.

Who is better here; the rabbit of the turtle? A sprinter of a marathon runner in a 10km race?

Appendix

Table 2: 10-year return of some stocks in Bursa

Table 3: 10-year Return of lemons