Enterprise Multiples Enterprise Multiples: The Value of Enterprise Multiples Chris Mayer explains what Enterprise Multiples he looks at when figuring out investment possibilities. Ten years after Ted Turner initially inked a deal that would result, after a year of negotiating with the FTC, in the merger of Time Warner and Turner Broadcasting (which had gone public 25 years earlier via a reverse merger with Rice Broadcasting)… Hello, Sleuths. Chris Mayer here. As Carl told you Tuesday, I routinely employ enterprise multiples in my search for appropriate investment candidates, and one metric I always look at is Enterprise Value -- not just market cap. Investors often make the mistake of just looking at market cap and comparing that to sales, earnings, book value, etc. By doing that, investors are making the same mistake they would if they looked at the value of their house by only looking at their equity. So you get a distorted picture of the value of the firm. Look at it this way: If you were going to buy the whole company outright for cash, you would have to buy the equity (market cap) and pay off the debts. Market cap does not take debt into account. Enterprise Value (EV) is market cap plus debt less cash. That’s right -- less cash. This can be important when you are looking at a company with loads of idle cash. The basic idea behind EV is to have something that you can compare with earnings and other measures, something that you can use to compare different companies with each other. So you don't want a company with a lot of cash to be "penalized" with a higher EV just because it's holding a lot of extra cash. Or think of the example of buying the whole company outright for cash. If you were going to purchase a business with $100 in assets and $100 in excess cash, you would pay $200, but you would get $100 back right away in excess cash. So the value of the business is really only $100 -- that's the number you want to compare with earnings, etc. So now that you have EV, you have something you can use to make comparisons. I like to compare EV to Tangible Book Value. Book value is easily found in a company's financial statement -- it's called Stockholders' Equity. To that number, I make a number of adjustments. I take out goodwill and other intangibles -- because I'm looking conservatively at what a company may be worth, and intangibles such as goodwill are hard to value and usually don't hold value in the same way that a building or a stand of timber does. I also make upward adjustments on some assets that are undervalued on the balance sheet. For example, if the company purchased a hotel, the value on the balance sheet is stated at cost. Even if the company bought the hotel in 1965, it's recorded at cost, while the market value of the hotel may, in fact, be some multiple of that. Enterprise Multiples: Enterprise Value vs. Tangible Book Value Now you are ready to make your first comparison: EV to Tangible Book Value. For value, you want to get as close to 1 to 1 as you can. In rare instances, you will actually get a number less than 1 to 1, meaning you have a stock that is worth less than the company's underlying assets. I found one such company in Orient-Express Hotels in October 2004. It's risen over 80% so far. Every once in awhile, you'll find such a gem, but most of the time, if you can pick up a good company for 1.2 or 1.5 times Tangible book value, you're doing pretty well. Of course, different industries have different relationships. You have to compare the number you get to other players. Sometimes whole industries get cheap or dear, as the case may be). I also compare EV to EBITDA (or Earnings Before Interest, Taxes, Depreciation and Amortization). But you have to be careful here. EBITDA does not take into account capital expenditures or changes in working capital -- and these can be big numbers and heavy users of cash. But EBITDA is a very rough measure of earnings power. If you get an EV to EBITDA in the single digits, you may have something special there. EV to EBITDA is sometimes called the "dealmaker's ratio." In my 10 years of corporate banking, I never heard it called that, but, whatever...Some journalist probably pinned it on the ratio because this is the number that so many takeover artists look at.
Anyway, these are two key numbers I look at. There are certainly others, but this is a good start. If you look at just these two things, you'll be taking steps that most individual investors don't take. However, it's common (and expected, really) among more sophisticated investors. Here are a few small-cap stocks that meet both criteria: National Western Life Insurance (NASDAQ: NWLIA) Superior Industries (NYSE: SUP) Industrias Bachoco SA de CV (NYSE: IBA) Presidential Life (NASDAQ: PLFE) (In the interest of fair disclosure, both IBA and PLFE are current holdings in my Fleet Street Letter portfolio...IBA is up about 50%, and PLFE is up about 13%). I want to stress though, that whereas valuation involves some number crunching, some of the most important aspects of investing are qualitative in nature, not quantitative. It involves judgment, in other words. You have to think like a business analyst and understand the strengths and weaknesses of the business. And you have to use common sense with a dose of contrarian skepticism -- perhaps the most important qualities of all. Chris Mayer
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