By Jae Jun. Originally published at ValueWalk.
In the great book, Deep Value, written by Tobias E. Carlisle, the enterprise multiple or the Acquirer’s Multiple, is discussed.
The acquirer’s multiple is defined in the book as:
Enterprise Multiple = EBITDA ÷ EV
EBITDA = Earnings Before Interest, Taxes and Depreciation & Amortization
EV = Enterprise Value = Market Capitalization + Debt – Cash
Carlisle asks the question: “Why is the enterprise multiple so good at identifying undervalued stocks?”
By analyzing returns from different valuation multiples, he says:
We found that both variations of the enterprise multiple had the most success identifying undervalued stocks, with the value portfolios of the EBIT form generating a compound annual growth rate of 14.6 percent and the EBITDA form earning 13.7 percent over the full period (for context, the S&P500 Total Return Index earned 9.5 percent). Wall Street’s favorite metric—the price-to-forward earnings estimate ratio—was by far the worst performing of the price-to-value ratios, earning a compound annual growth rate of just 8.6 percent and underperforming even the market.
Let’s put this great book aside for a few seconds, and see an article from the Economist discussing the valuation levels from 2015 when this article was originally written. The information is still very relevant today.
The Economist: The New Rules of Attraction
A recently published article in the Economist, Mergers and acquisitions: The new rules of attraction, discusses the market valuation levels compared to earlier periods.
Whether deal making is sensible is once more an important question, because M&A are back with a vengeance after a lull following the financial crisis. Worldwide, $3.6 trillion of deals have been announced this year, reckons Bloomberg, an information provider, approaching the peak reached in 2007. In pharmaceuticals (see article) and among media firms the activity is frantic. Deals worth more than $10 billion are again common. America and Britain, with their open markets for corporate control, account for a disproportionate share of the action. So do cross-border deals, which have risen from a sixth of activity in the mid-1990s to 43% today.
The first part of the article discusses whether or not there are any value-added to be expected from mergers and acquisitions. A relevant question by any means. Here is what the article has to say:
On paper, M&A make sense. When two firms combine they can cut duplicated overheads, raising their margins. By adding together their market shares they can gain pricing power over customers and suppliers. By cross-selling each other’s product ranges in each other’s geographic markets, merging firms can make their combined sales a lot bigger than the sum of their individual ones.
M&A folklore, however, dwells on giant catastrophes, such as the combinations of Time Warner and AOL in 2000 just as the dotcom bubble burst, or Royal Bank of Scotland (RBS) and ABN AMRO in 2007, as the subprime crisis struck. Yet some of the world’s most successful firms are the result of giant deals. Exxon became the energy industry’s top dog thanks to its purchase in 1999 of Mobil, which had an under-appreciated collection of global assets. AB Inbev has done $100 billion of deals over two decades to become the world’s biggest brewer, with thirst-quenching profits.
The second part of the article discusses the cycles of history and looks at the current valuation level in deals that have closed. Having a firm grasp of how history played out, can sometimes serve as a guide going forward. Even if history doesn’t repeat, maybe it does rhyme? Anyways, about the cycles of history, the article says:
Cycles of History
The first test is whether a bandwagon is rolling, with corporate bosses jumping aboard unthinkingly. In America between the 1890s and the early 1900s there was a craze for creating monopolies, in steel, tobacco and other industries, prompting trustbusting laws to break them up. In the 1960s conglomerates were in fashion; by the 1980s these lumbering giants were also being dismantled, with the aid of the newly created junk-bond market. In 1999-2000, during the dotcom bubble, technology and telecoms firms accounted for 40% of activity, only to be among the biggest to pop subsequently. In the last surge of deals, in 2003-07, several bandwagons were rolling, including a rush into emerging markets and commodities, and a gallop into private-equity buy-outs. (These accounted for a quarter of deals in 2007, but are down to 19% so far this year.)
So far this time there is no widespread mania. There are pockets of silliness: the pharmaceutical industry is in a frenzy of “inversion” deals, in which American firms buy foreign ones in order to switch their domiciles and avoid American tax rules. But inversions account for only 9% of M&A activity so far this year.
Meanwhile, there are lots of relatively unadventurous deals, says Roger Altman, the boss of Evercore, an investment bank. These seek to build firms’ shares of existing markets, strengthen their product portfolios and cut costs rather than to enter completely new industries or distant countries.
Among the biggest of these, Comcast’s $68 billion bid for Time Warner Cable will, if regulators approve it, give the bidder control of 17 of the top 25 cable markets in America. GSK and Novartis, two drugs firms, are swapping assets to bolster their respective strengths in vaccines and oncology. Verizon’s $130 billion purchase of Vodafone’s share in their American mobile venture was the largest deal in 2013-14 but hardly a leap into the unknown: Verizon already manages the business.
In a further reflection of the restrained mood, some serial acquirers have gone into reverse, divesting or spinning off assets, notes John Studzinski of Blackstone, a financial firm. Dismemberments tend to be investor-friendly. Altria, a conglomerate that included Philip Morris and Kraft Foods, was created in a flurry of deals in the 1980s and 1990s. Since 2007 it has split itself into four main parts, that are today worth $333 billion, almost double what the combined group had been worth.
In October Hewlett-Packard said it would spin off its personal-computer business, reversing its acquisition of Compaq in 2001 (while also offloading its printers business). BHP Billiton, an Australian miner, has been one of the most acquisitive companies in history. But it now wants to spin off its metals and coal businesses, largely reversing a merger that created the firm in 2001 (though it shelved the sale of part of the metals business this week, after failing to get a good price for it).
The trend for spin-offs may have further to go. Plenty of multinationals plunged into emerging markets just before these countries’ economic growth rates slowed: now some of them will be getting cold feet. And many of Asia’s biggest firms, such as Tata Sons in India, Hutchison Whampoa in Hong Kong and Samsung in South Korea, are sprawling conglomerates that may in time be broken up.
The present M&A boom passes the first test: there is little sign of senseless bandwagon-jumping. The second sanity test is the extent of speculative financing and stretched valuations. Here the news is less good. Admittedly, the average premium paid by an acquirer as a percentage of the target’s share price, at 23%, is in line with the 20-year average. But this measure tends to be a poor guide to peaks and troughs. Two other measures are less reassuring.
First, lots of deals are being
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