Lesson 4: The Acquirer’s Multiple

End nearWhat happens if you get scared half to death twice?  –S. Wright

We were unable to discover any ‘magic’ qualities associated with stocks selling below liquidation value. — Joel Greenblatt (How the Small Investor Can Beat the Market)

Enterprise Multiple = Earnings before interest, taxes, and depreciation & amortization, (“EBITDA”) divided by Enterprise Value (“EV”).

We need to understand the use of EBITDA, Why we must use EV, and the requirement to use pre-tax owner’s earnings or EBITDA – maintenance capex (“MCX”).

Placing EBITDA into Perspective (from the prior post) Suggested reading

EV The Price of a Business  Understanding and calculating EV. Suggested reading

Beginning lesson on Enterprise Value for beginners (Video, Khan Academy)

Pop Quiz: Why do you include minority interests with EV?

Why you use Enterprise Value (Review)

Minority Interests (Review)

Chapter 9 EV Multiples  Only if you dare. Heavy reading. Voluntary.

Let’s tackle really grasping the use of EV, EBITDA, and EBITDA – MCX

I will also send out the Little Book via email as supplementary reading for this chapter.

Good luck.

8 responses to “Lesson 4: The Acquirer’s Multiple

  1. John,

    These materials are very interesting.

    Another thing that I’ve found helpful is Table 3.3 on page 80 of Penman’s “Financial Statement Analysis and Security Valuation” (5th ed). The table sets out a historical analysis of the distribution of various multiples, including EV/EBITDA and EV/EBIT. (Unfortunately, my scanner is broken so I can’t post a copy of it to your DEEP-VALUE Google Groups site.)

    Cheers,

  2. OK, I will look it up and see if I can convey it to the group. THANKS! The main thing is that students not just slap EV/EBIT multiples on companies without understanding true owner’s earnings. Use multiple sign posts of value.

  3. John – where is that chapter 9 from?

  4. Chapter 9: Value Multiples from Damodaran on Valuation, Second Ed.
    you can find a free pdf on his web-site.

  5. Thanks John

  6. There hasn’t been much discussion on Toby’s chapter, so let me kick off with some controversial points.

    I think that Toby is right to focus on the EV/EBIT ratio, but I get there by a different process of reasoning.

    At it’s most basic, the “margin of safety” concept is just an elegant way of saying that you should buy a business for less then it’s worth. I believe that the value of a business revolves around it’s earning power. So, if you assume that last year’s earnings are indicative of a business’ earning power, then a low P/E ratio is a good starting point in terms of finding companies for which there is an adequate margin of safety.

    However, the P/E ratio suffers from several shortcomings, each of which can be avoided by focusing on the EV/EBIT ratio. To summarise:

    1. The P/E ratio depends heavily on the true EPS. Unfortunately, the accounting standard for the calculation of EPS is very lengthy and complex. Moreover, when you dig into the detail, that accounting standard contains several rules which are arbitrary, to say the least. (I’m working in a modified IFRS environment; don’t know what the position is under US GAAP.) The complexity and arbitrary nature of some of the rules suggests to me that this is an area which attracts manipulation. All these problems can be side-stepped by simply looking at the company as a whole, which is what the EV/EBIT ratio does.

    2. The P/E ratio is very sensitive to how the business is funded, that is, whether by debt or equity. In many situations, you can improve a company’s net earnings simply by taking on more debt. However, at a deeper level, I think that a company’s intrinsic value depends on its operating characteristics, rather than mere financial engineering. It follows that it’s better to focus on the operating earnings of the company, calculated in way which excludes financial income and expenses. That is another plus for the EV/EBIT approach.

    3. The P/E ratio depends on net profits after tax. The problem here is that the “income tax expense” you see reported in a profit and loss account is determined by reference to the accounting standard on tax effect accounting. That standard is an atrocity. It usually produces a reported “income tax expense” which differs considerably from what is shown in the company’s income tax return. It causes other distortions too, for example, as to how carried forward losses are treated. These issues can be circumvented by using the EV/EBIT ratio, rather than the P/E ratio.

    Obviously, even if you use EV/EBIT, that leaves the question of whether your EBIT figure is indicative of the true earning power of the company. So you have to so some work to estimate the normalised EBIT, over the business, as best you can.

    There are some other quibbles I have about Toby’s chapter, but I’ll leave it here for now.

  7. I think a lot depends on how you want to play things.

    EV/EBIt can get you into a lot of trouble if you buy cyclicals when they’re most profitable.

    If you want to buy Deep Value, then look for a discount to NCAV. You should see very low prices to book. As Carlisle points out, it’s generally the loss-makers that outperform.

    So looking at EV/EBIT can be a red herring, or even a big mistake.

    Investors need to ask themselves: is this a quality company (like Coca Cola) or a cyclical (like miners and energy). Quality companies should be looked at on the basis of EV/EBIT. For cyclicals, forget EV/EBIT, and concentrate on balance sheet strength and where we are likely to be in the cycle. Of course, no-one knows how bad a cyclical sector can get. You can buy low, only to see it go much lower. But when you see things like “the death of … ” and “… and experts expect it to go lower” you should probably take those as signals to buy. In the UK, for example, it’s not difficult to find mining and energy companies trading at half book. Everybody can tell you why you shouldn’t buy them, but I’m sure we’ll all be using oil, iron, copper, platinum, etc. a decade from now.

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