kcchongnz blog
Enterprise Value and Acquirer’s Multiple kcchongnz
“If something is easy to compute and understand, it is extremely unlikely that the market will misinterpret it. Therefore, such information will not, by itself, provide evidence of mispricing”
The trick to obtain extra-ordinary return from the market is not just in buying good companies at whatever prices, but buying them cheap. Buying the best looking, best furnished house for RM10m in a suburb of similar houses averages RM1m each is not a wise investment decision. Hence we must a feel of the price versus the value of a stock.
Surprisingly most retail market players do not have a clue of that. Those who do, for example loaded market players, remisiers, including my own remisiers, most analysts and investment bankers, at most would use the simplistic price-earnings (PE) ratio as a yardstick for determination of price versus value.
Have you heard of people who bragged about making tens or hundreds of millions from the stock market that they don’t even need to understand or look at the balance sheet? And that it is a non-issue for a company to have loads of debts as long as it makes profit, and no need to care about if its earnings or cash flows can’t even pay for its interest expense?
For a company without debt, it may be adequate to just use the PE ratio. However, as many companies have substantial amount of debts in their balance sheets, the use of the simplistic PE ratio would have miss the forest for the tree. Here is why.
Considering this. Two companies, A and B in exactly the same industry have the same number of shares with the same share price and market capitalization of 100m as shown in Table 1 below.
Table 1
|
Company |
A |
B |
|
No. of shares, m |
100 |
100 |
|
Share price |
1.00 |
1.00 |
|
Market Cap, m |
100 |
100 |
|
Total debt, m |
50 |
10 |
|
Excess cash |
10 |
20 |
A has a total debt of 50 million and an excess cash of 10m, whereas B has a total debt of 10m but an excess cash of 20m. Table 2 below shows the income statements of the two companies:
Table 2
|
Company |
A |
B |
|
EBIT |
15.8 |
13.8 |
|
Interest |
-2.5 |
-0.5 |
|
EBT |
13.3 |
13.3 |
|
Tax @ 25% |
-3.3 |
-3.3 |
|
Net income |
10.0 |
10.0 |
Both companies make a net income of 10m. Hence both A and B is selling at the same price-earnings ratio of 10 (100m/10m). But are the two same PE ratios any different?
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 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.
TEV of A in the above example is 140m (100+50-10) and B is 90m (100+10-20). Clearly Co. A is much more expensive than Co. B. In fact it is 56% more expensive than Co. B in term of price. We can clearly see that debt and cash can have an enormous impact on a particular company's enterprise value. Hence when evaluating the fair price of a company or comparing companies, a better measure of value is the enterprise value over the earnings before interest and tax (EBIT), or the operating income, instead of the too simplistic or flawed PE ratio.
For highly indebted businesses, the earnings before interest, tax, depreciation and amortization, or EBITDA is often used by creditors of the company to assess its interest paying capability and comparison among companies in the similar industry.
In this evaluation with enterprise value, it has the advantage that the capital structure is included. High level of debt makes a business less attractive and cash holdings on the other hand is rewarded.
Enterprise value is very often used by investment bankers in acquisition and merger exercises, for the reasons apparent in the above explanation.
Does the above explanation of enterprise value and its importance sounds like pure theory, or an economic concept, and of no use in real life investing?
Acquirer’s Multiple (TEV/Ebit)
For Table 2 above, both A and B produce the same net income of 10m, but A has a higher EBIT of 15.8m and B a lower EBIT of 13.8m. However, the TEV/EBIT for A is 8.9 times (140/15.8), 36% higher than the 6.5 times (90/13.8) of B.
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 example what we have done to compare company A and B above.
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 Buffet’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.
Enterprise value of Scientex
This is a response to the post here and some comments there.
http://klse.i3investor.com/servlets/forum/600084607.jsp
Table 3 shows the computation of the enterprise value of Scientex based on its 2015 annual financial results.
Table 3: Enterprise value of Scientex
The computation of the above should all be based on the market value of each of them, just like that of the equity shareholder, of which market capitalization is used, instead of “equity attributed to common shareholders” in the balance sheet. This is because that is the market price the shareholders are willing to sell to the acquirer, not the “Equity” which is a historical number.
Similarly for debts, minority interest (MI), and investments. If you have the market value of debt, use them, but for a good company, book value of debts generally doesn’t differ much from the market value. Market value of MI can be estimated by MV MI = BV MI * P/B as shown. Short cuts were taken for the investments by taking the book values but as they are relatively small and have no significance to TEV.
Note I do not use the term “excess cash” but “cash and cash equivalent”. This includes investment in quoted and unquoted shares, short-term money market funds etc., which are not required for the ordinary operations.
One cannot use the working capital as part of the “excess cash” and less off from the enterprise value. Working capital is not “excess cash” as it is part of the operating assets of the enterprise of which you derive your TEV from. These are the assets you need to do your business in your enterprise. You can’t squeeze off the working capital from the operating assets.
Investments, such as investments in joint venture and associates, other investments are also excluded from TEV computation as they are not related to the ordinary operations, and can be sold off separately without affecting the ordinary operations.
Enterprise multiple of Scientex
The operating profit for Scientex in 2015 is RM225m. Hence the Ebit multiple is 1956/225 = 8.7, or a before-tax earnings yield of 11.5%. This multiple is not cheap. But if you consider the high growth potential of Scientex in its PVC/PP/PE business, and as a regional market leader, it may not be expensive.
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.
For those who wish to learn about this stuff, please email me at
KC Chong
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Discussions
5 people like this. Showing 33 of 33 comments
Mr. Chong,
I have another question.
TEV = Market Capitalization + Debt + Minority Interest - Cash – other non-operating assets
Why take the total cash instead of excess cash only?
I am using this equation - TEV = Market Capitalization + Long Term Debt + Minority Interest - Excess Cash – other non-operating assets
2015-10-19 14:49
And, the definition of my Excess Cash is not the working capital, but Excess Cash = Total Cash – MAX(0,Current Liabilities-(Current Assets-Cash))
2015-10-19 14:56
E.g. PTARAS - I need to dissect the income items based on financial note (7) and compute the pure "Operating Profit"
#financial note (7) is available at page56 of PTARAS AR 2015 (http://www.klse.my/staticFile/371065.jsp)
2015-10-19 15:02
II,
Yes, many companies have some non-operating profit such as dividend income, interest income etc in their "Operating income". It could be the accounting rule for companies with a lot of cash and share investments.
What we can do is look at what they are, maybe from the cash flow from operating activities, and exclude them from operating income to do our other analysis such as DCFA, or comparing with other companies.
You can use your formula,
Excess Cash = Total Cash – MAX(0,Current Liabilities-(Current Assets-Cash))
But replace then with non-cash current liabilities and non-cash current assets.
that will avoid double counting in your cash and debts.
Ultimately, you will arrive the same answer as mine.
2015-10-19 15:05
Thanks for sharing KC.
We want to subtract excess cash from the Enterprise Value because the portion of total cash needed to cover current liabilities is an investment in the company.
Excess Cash = Total Cash – MAX(0,Current Liabilities - (Current Assets - Total Cash))
Excess Cash = Total Cash - MAX (0, Current Liabilities - Current Assets + Total Cash)
So, fundamentally, what is the difference between your EV and my proposed EV?
We want excess cash to be a positive number. Therefore, we guard against this by putting a maximum of 0 on the value to subtract from cash.
I am keen to learn and use the right one.
2015-10-19 15:32
"We want excess cash to be a positive number. Therefore, we guard against this by putting a maximum of 0 on the value to subtract from cash."
The maximum of 0 is not to guarantee excess cash >0. It actually ensures that Excess cash never exceeds total cash. It is a way to conservatively estimate excess cash since it will not consider any the residual value of net working capital and add it back to cash.
The enterprise value calculation should be based total cash and equivalents instead of excess cash. I realized this now because in the excess cash calculation, short term debt is included in the computation hence you are double counting if you also include short term debt in the enterprise value equation.
2015-10-19 15:39
Hi Mr. Chong
I am getting the non cash CA with Current Assets-Cash.
And, what's non-cash current liabilities?
2015-10-19 15:43
Posted by Intelligent Investor > Oct 19, 2015 03:43 PM | Report Abuse
Hi Mr. Chong
I am getting the non cash CA with Current Assets-Cash.
And, what's non-cash current liabilities?
It is total current liabilities - short-term debt
Short-term debt is already in "Total debt" in the EV formula
2015-10-19 15:55
Hi. Mr Chong,
Thanks.
If this is the case, I think I can remain my current equation. Because I prefer to minus it out to checkout how much is the "real" Excess Cash and what is the % of Excess Cash on the Total Asset and Market Cap.
By doing so, I only take in the Long Term Debt on TEV. Where, TEV = Market Capitalization + Long Term Debt + Minority Interest - Excess Cash – other non-operating assets
2015-10-19 16:05
Posted by angiegoh > Oct 19, 2015 03:32 PM | Report Abuse
Thanks for sharing KC.
We want to subtract excess cash from the Enterprise Value because the portion of total cash needed to cover current liabilities is an investment in the company.
Excess Cash = Total Cash – MAX(0,Current Liabilities - (Current Assets - Total Cash))
Excess Cash = Total Cash - MAX (0, Current Liabilities - Current Assets + Total Cash)
So, fundamentally, what is the difference between your EV and my proposed EV?
We want excess cash to be a positive number. Therefore, we guard against this by putting a maximum of 0 on the value to subtract from cash.
I am keen to learn and use the right one.
Angiegoh,
Noby has answered your question well. I just want to add here.
Forget about this formula of excess cash. It will confuse you. Use the intuitive EV formula as
TEV = Market Capitalization + Debt + Minority Interest - Cash – other non-operating assets
And the explanation in my article here.
The "excess cash" in your formula will give you a maximum of the cash or cash equivalent in the balance sheet, and no more.
Most if not all companies require a positive net working capital for its business, otherwise it will have liquidity risk. Net positive working capital is required in its operating assets. So you can't "extract" any more cash from there.
Mind you, we are talking about EV, not liquidation value.
2015-10-19 17:18
Hi Angie,
Ill breakdown your formula, I will exclude minority interest and preferred to make it cleaner.
EV = Market Cap + Borrowings - [Excess cash]
EV = Market Cap + Borrowings - [Net working capital]
EV = Market Cap + Borrowings - [Current assets - current liabilities]
EV = Market Cap + Borrowings - [Development cost + Inventories + Receivables + Cash & bank balances - Borrowings - Trade payables - Dividend payables - Tax liabilities]
You see your formula is adding borrowings and minus borrowings again. Another thing is EV = Operating assets when you refer to the pictorial above. In some ways, you are double counting many things and canceling things off like borrowings.
2015-10-19 17:53
Well done and thanks JT, Noby, and Kc! It could not be clearer now.
One last question: why subtract other non-operating assets in EV calculation?
2015-10-19 18:20
Because they are 'non-operating'. As Toby said, just like those excess cash, something that can be redeployed if necessary without jeopardising daily operations of the business.
2015-10-19 19:32
So, this is final:
EV = Market Capitalization + Debt + Minority Interest - Cash – Other Non-Operating assets
I can't tell that how much I enjoyed the discussion and argument, which both turned out to be fruitful and useful.
Long value investing.
2015-10-19 20:00
Simple mah, EV is calculated from the point of view you wanna sell away company. Normally ppl will sell debts together,and also keep non relating business. Cash deducted as after takeover ppl take cash , so it act as contra
2015-10-19 20:04
Hi Angie, I will suggest you please change all your posts valuation as it mislead people on executing a non official calculation. Thank you so much and very much appreciate your effort. Please keep it up, would love to see more of your posts.
2015-10-20 00:24
Interesting discussion, really appreciate you all for the sharing. It is blogs and discussion like this which attract me to here.
2015-10-20 13:45
"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 Buffet’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."
Hi KC, is the benchmark of TEV/EBIT<7 apply for all companies? Are there any industries benchmark?
Thank you!
2015-10-20 14:27
EV = Market Capitalization + Debt + Minority Interest - Cash – Other Non-Operating assets
whether to include Other Non-Operating assets is arguable. if tht assets can sell together, then include.
2015-10-20 14:56
And one more qusetion, the growth rate 8% referring to revenue?EBIT?PAT?EPS?
2015-10-20 14:57
It amazes me how widespread the use of EBITDA has become. People try to dress up financial statements with it.
We won't buy into companies where someone's talking about EBITDA. If you look at all companies, and split them into companies that use EBITDA as a metric and those that don't, I suspect you'll find a lot more fraud in the former group. Look at companies like Wal-Mart, GE and Microsoft -- they'll never use EBITDA in their annual report.
People who use EBITDA are either trying to con you or they're conning themselves. Telecoms, for example, spend every dime that's coming in. Interest and taxes are real costs."
Source: Berkshire Hathaway Annual Meeting 2002 Tilson Notes
Time: 2002
2015-10-20 15:05
Posted by Chin Pin Tan > Oct 20, 2015 02:27 PM | Report Abuse
"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 Buffet’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."
Hi KC, is the benchmark of TEV/EBIT<7 apply for all companies? Are there any industries benchmark?
It is a good benchmark as explained in the statement. But in investing, nothing is cast in stone.
2015-10-20 15:41
Hi KC , if someone is not so good in calculation and use the formula you teach above ,do you think that we can use the ratio of return of equity (ROE)and combine with PE ratio to make it simple ?
2015-10-21 03:48
Why operating profit is used instead of earning before income tax for ebit? I'm a bit lost here
2015-10-21 21:29
Hi Miketyu, non operating assets are the assets not related to the business operation, such as investment in associate company. We have to minus it when we calculate the TEV.
ebit is the short form of earning before interest and tax (not the earning before income tax), which is equivalent to the operating profit.
We usually use operating profit (or ebit) to assess whether the company is doing well in its operating activities.
Hope the above explanation is useful for you.
2015-10-21 21:40
hi kcchongnz
may i know where did you get the figure for Minority interest = 116813 ?
2016-02-26 11:20
Posted by natelietan > Feb 26, 2016 11:20 AM | Report Abuse
hi kcchongnz
may i know where did you get the figure for Minority interest = 116813 ?
It is from the balance sheet equity section
2016-02-27 22:19
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Hi Mr. Chong,
Some companies include the return from investment in the EBIT.
If TEV = Market Capitalization + Debt + Minority Interest - Cash – other non-operating assets
I think it might be a better idea to use the Operating Profit (we might need to dissect the income statement to get this figure) which exclude all profit from the non operating asset to get the Acquirer’s Multiple
I would suggest to make use this equation - Acquirer’s Multiple = TEV/Operating Profit
2015-10-19 14:47