The Acquirer's Multiple: How the Billionaire Contrarians of Deep Value Beat the Market

by Tobias E. Carlisle

Let’s say we have two stocks that are the same in every way but one. Both have a market cap of $10 million. One has $5 million in debt, and the other has $5 million of cash in its bank account and no debt. Which one is cheaper? The company with $5 million in cash is cheaper than the one with $5 million in debt. But we can’t tell from the market cap alone. Both have an identical market caps of $10 million. Why is the company with $5 million in cash cheaper than the company with $5 million in debt? Let’s look at what happens when we acquire all of the shares of each company.

Enterprise Value: Debt is Bad and Cash is Good

The enterprise value penalizes the company with debt by adding the debt onto the market cap. It rewards the company with cash by taking away the cash from the market cap. The company that owes $5 million in debt has an enterprise value of $15 million ($10 million in market cap + $5 million in debt). The company with $5 million in cash has an enterprise value of $5 million ($10 million in market cap – $5 million in cash).

The enterprise value includes two other important costs that are like debt: preferred stock and minority interests. Preferred stock is stock that pays its holder a preferred dividend. (It is preferred because it is paid before the common stock dividend and has some other rights the common stock doesn’t have. If the company doesn’t have enough money to pay both, it can only pay the dividend on the preferred stock.) It is like debt because the dividend is fixed and must be paid regularly, just like interest. The enterprise value penalizes companies with preferred stock by adding the preferred stock on to the market cap. A company with a $10 million market cap and $10 million in preferred stock has an enterprise value of $20 million ($10 million + $10 million = $20 million).

Negative Enterprise Value: Extra Cash Is Great

Companies with enterprise values of $0 (and less) do exist. A low or negative enterprise value is a good thing to find. It means the company has little debt and lots of cash relative to the market cap.

This is why we say the enterprise value is the true price of a company.

In his letters to shareholders, Warren Buffett often writes that he tracks “operating earnings before interest and taxes.” At Berkshire, he says his “main focus is to build operating earnings.”41 So what are operating earnings?

Buffett says, “The ‘operating earnings’ of which we speak here exclude capital gains, special accounting items and major restructuring charges.”42 Operating earnings is the income that flows from a business’s operations. It leaves out interest and taxes. It also leaves out unusual, one-off things like gains from selling an asset or settling a lawsuit. The one-off items are left out because they won’t occur again in the future. They don’t show the usual operations of the business.

Operating Earnings = Revenue - Cost of Goods Sold - Selling, General, and Administrative Costs - Depreciation and Amortization

Operating earnings are very similar to earnings before interest and taxes or EBIT.

By excluding special items—income that a company does not expect to recur in future years—ensures that these earnings are related only to operations.

Investors use operating earnings to make an apples-to-apples comparison between stocks. For example, let’s say we have two identical companies, but one has a lot of debt, and the other has none. The company with a lot of debt will pay a lot of interest, and its tax will be lower. It will have a lower net income. The company with no debt will pay no interest and more tax. It will have a higher net income.

An Acquirer’s Multiple of 5 is cheaper than an Acquirer’s Multiple of 10.

“Our statistical screens are merely exploiting a group of undervalued stocks that are easily identified and are further protected by strong balance sheets and large asset values. Additionally, because of the depressed nature and liquid make-up of the companies that meet our test criteria, they are often the object of takeover initiatives.” —Joel Greenblatt, “How The Small Investor Beats The Market” (1981)

This method looks for stocks with more cash and other liquid assets than debt. Then it buys only those stocks at a big discount to the net value. Graham said it was “foolproof” and “unfailingly dependable.”45

intrigued.

“We were unable to discover any ‘magic’ qualities associated with stocks selling below liquidation value”:46

First, the stocks are undervalued. And the more undervalued they are, the bigger the return. Graham’s instinct about the margin of safety is right. The greater the discount, the bigger the gain.

He split the stocks into two groups. One had only profitable stocks, and the other, only loss makers. Oppenheimer found the loss makers beat the profitable group.

He split the profitable group again. The first group was comprised of dividend-paying stocks. The second group paid no dividend. Oppenheimer found the stocks that didn’t pay a dividend beat the ones that did.

Mean reversion pushes up the beaten-down prices of undervalued stocks. It pushes up beaten-down businesses, too.

In Security Analysis, Graham wrote that if asked to “distill the secret of sound investment into three words,” he would say “margin of safety.”

The greater the company’s discount to its value, the bigger the margin of safety. The bigger the margin of safety, the better the return and the lower the risk. A wide discount allows for the ordinary errors in calculations of value, and it allows for any drop in value.

Find a margin of safety in a company’s balance sheet. Many, many stocks have sunk due to too much debt. We need to make sure the stocks have more cash than debt or that the debt is small relative to the business. The Acquirer’s Multiple favors exactly these stocks.

Find a margin of safety in a company’s business. The company should own a real business, which should have historically strong operating earnings with matching cash flow, which confirms the accounting earnings are real. It means they are not the creation of a clever embezzler’s mind. We should also look for signs of earnings manipulation. This can be the first step down the road to fraud.

But weak current profits in a stock with a good past record creates a good chance for deep-value contrarians to zig.

Why do fair companies at wonderful prices beat wonderful companies at fair prices? Because great businesses don’t stay great. They only look great at the top of their business cycle. Mean reversion pushes great business back to average.

The reason great businesses become average businesses is mean reversion. Things go back to normal. It means profits move back toward the average over time. A great business is an outlier. It is more profitable than average. Over time, competitors eat away the unusually high profits until the business earns average profits.

Here is the simple truth: profits move toward the average over time. Only some stocks avoid it, and we don’t know why. Without Buffett’s genius for business analysis, we can’t rely on a high-profit business staying that way. This is why fair companies at wonderful prices beat wonderful companies at fair prices.

Investors expect stocks with profits that have gone up for a few years to keep going up. And they think stocks with a few years of falling profits will keep going down. Stocks with rising profits get expensive because investors expect the profits to keep going up.

And stocks with falling profits become undervalued because investors expect the earnings will keep falling. In other words, investors don’t expect profits to mean revert. But they’re wrong. Mean reversion is the likely outcome.

Book value is the value of a company’s assets (what it owns) less its liabilities (what it owes). It is one measure of a company’s value. Price-to-book value measures how much you pay for that value. If you pay less than book value, you may be getting a bargain. If you pay more than book value, you may be overpaying.

De Bondt and Thaler’s findings are good evidence of mean reversion in profits.

The big declines turn into growth. And fast growth slows down. As a result, undervalued stocks’ profits go up faster than expensive stocks’ profits. Undervalued stocks’ prices go up more than the market, too. If we want high profit growth and a stock price that goes up faster than the market, we should look at undervalued stocks.

Mean reversion means the stock prices of undervalued stocks are likely to rise over time, and the stock prices of expensive stocks fall.

Wonderful stocks lag because investors overestimate future growth and profits. Fair businesses beat the market because investors underestimate the change in the stocks’ price-to-value ratio. Undervalued stocks trend toward the average value, and the price rises. Expensive stocks trend toward the average value, and the price drops.

Economic profit is calculated as ROIC – WACC. “ROIC” stands for “Return On Invested Capital.” It’s another name for return on equity or return on capital. ROIC measures how much money a business makes for each dollar invested in it.

“WACC” stands for “Weighted Average Cost of Capital.”

It measures the rate the market charges a business for its capital. On debt capital it is the interest rate. On equity capital it is ...

The market charges riskier firms more, and safer firms less. In practice, this means riskier firms should expect a lower PE, and safer firms a higher PE. The difference between ROIC and WACC is economic profit. This analysis recognizes that capital isn’t free. A business is only wonderful if it mak...